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banking sectorIntroduction

A major problem being observed all over the world in the banking sector is problem of bad loans. First step of building a stable and strong financial system is to minimize non-performing loans. According to World Bank, non-performing loans as proportion of total loans is 24..6 % for Ireland, 31.3 % for Greece, 9.5 % for Egypt, 6% for Russia, 3.6% for South Africa, 3.2% for USA, 2.9 % for Brazil and 1% for China. Non-performing loans have been huge concern for al the nations across the globe. Since the introduction of financial sector reforms in 1992 and second phase of reforms in 1998, the recovery of non-performing assets is considered as one of the biggest problems for the entire banking industry in India. The high level of Non-Performing Assets (NPAs) taints the overall portfolio but puts a burden on the income statement of banks in the form of higher provisions. The earning capacity and profitability of many banks are adversely affected by the high level of NPAs. Though it is not possible to have zero NPAs, a proper understanding of NPAs is required to manage them, with a view to keeping them under control. To understand NPAs, it becomes imperative to understand the determinants of NPAs both from the regulatory as well as managerial angles. For the regulator, NPAs are crucial since they constitute the first trigger of banking crises. For the bank manager, NPAs reduces the bank’s profitability, as banks are not allowed to book income on NPAs and, at the same time, required to make provision for such accounts as per the regulator’s guidelines. Moreover, managerial and financial resources of the bank are diverted towards resolution of NPA problem causing lost opportunities for more productive use of resources. A bank saddled with NPAs might tend to become risk averse in making new loans, particularly to SMEs. Hence an attempt is made to understand the determinants of the performance of the banks based on asset quality measured by the level of non-performing assets in a bank subsequent to the recommendations made in Narasimham committee report and Global financial turmoil.

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Exports Xy = NjXy from country i to country j are shown in the lower panel of Figure 1.

Within the interval (La,Lb) both countries are producing the Coumot-Nash good, and they will also both be exporting provided that the F.O.B. price received (which is net of transport costs) exceeds marginal cost. This will be true in Figure 1 provided that P/% > с , as we shall assume.4 When L]=La then exports of the Coumot-Nash are zero because production is also zero, but as country 1 grows then exports also rise, as illustrated by the curve Xn. When Li=Lb, country 2 ceases production of the Coumot-Nash good. Further re-allocations of labor towards country 1 reduce its exports, because demand falls in country 2.5 Thus, the general shape of exports from country 1 are as illustrated by X12, increasing from La and then decreasing after Lb. The corresponding export curve X21 from country 2 is also illustrated.


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The conditions in (6) are simply arbitrage conditions, needed to ensure that goods exported from country i to j cannot be profitably re-exported back to i. That is, the price received from re-exporting, pi/Tjj, should not exceed the purchase price in country j, pj. When this condition holds as an equality, the number of firms located in the country with the higher price is zero: import competition eliminates the local firms. To understand this result, note that when pi/T2i=P2> the price in country 1 is sufficiently high to offset fully the barrier created by transporting from country 2. We can think of Р1/Т21 as the F.O.B. (“free on board”) price received for country 2 exports, the price net of transportation charges. When this equals the home price P2, a firm in country 2 will have the same market share in its export and home markets, as can be seen from (3). From (4), the only way for the market shares to add up to unity is for all the firms to be located in country 2; intuitively, the firms in country 1 have been eliminated through import competition.
where a denotes the share of the Coumot-Nash good in the total consumer’s budget (which depends on the relative price of that good).


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Our theoretical results indicate that the home market effect should be larger for differentiated goods with free entry than for homogeneous goods with restricted entry. We test this hypothesis in our empirical work. We regress bilateral exports (from one country to each of its trading partners) on domestic- and partner-country GDP (and other controls). We are interested in the elasticity of exports with respect to domestic GDP, since our theory indicates that the size of this elasticity depends on the type of good.

We expect to see higher elasticities for manufacturing goods with few entry barriers, and smaller elasticities for homogeneous goods with more entry barriers (e.g., because they are resource-based). Using Rauch’s (1999) classification, we divide our sample into three; homogeneous goods, differentiated goods, and an in-between category.

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It is well-known that international trade flows can be well described by a “gravity equation” in which bilateral trade flows are a log-linear function of the incomes of and distance between trading partners. Indeed, the gravity equation is one of the greater success stories in empirical economics. However, the theoretical foundations for this finding are less clearly understood. The gravity equation is not implied by a plausible many-country Heckscher-Ohlin model (which has nothing to say about bilateral trade flows). An equation of this type does arise, however, from a model in which countries are fully specialized in differentiated goods.

While specialization might characterize manufacturing goods, it is presumably not a feature of homogeneous primary goods. Despite this theoretical presumption, the gravity equation seems to work empirically for both OECD countries and developing countries (Hummels and Levinsohn, 1995). Since developing countries tend to sell more homogeneous goods, it seems puzzling that the gravity equation works well for these countries. Thus, it is hard to reconcile the special nature of the theory behind this equation with its empirical performance.

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Our constrained solution enables us to study the welfare effects of bond indexation in a realistic framework. When portfolio constraints are in place, and both nominal and indexed bonds are available to investors, more conservative investors hold in their portfolios relatively more indexed bonds than nominal bonds. These investors benefit substantially from the consumption insurance provided by long-term indexed bonds.

We have also studied the demand for bonds when equities are available as an alternative investment. We find that the ratio of bonds to stocks in the optimal portfolio increases with risk aversion, very much in line with popular investment advice but contrary to the mutual fund theorem of static portfolio analysis. However the demand for long-term bonds is only large when these bonds are indexed, or when inflation uncertainty is low as it has been in the Volcker-Greenspan monetary policy regime since 1983.

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A weakness in this resolution of the asset allocation puzzle is that it assumes that long-term bonds are indexed, or equivalently, that there is no inflation uncertainty The portfolio allocations to nominal bonds in Table 8 do not correspond well with popular investment advice. In order to rationalize the popular investment advice for long-term nominal bonds, one must assume that future interest rates will be generated by a different process than the one estimated in 1952-96, a process with less uncertainty about future inflation. Interestingly, we have estimated just such a process over the Volcker-Greenspan sample period 1983-96. Table 9 repeats Table 8 using our 1983-96 estimates and finds that even when only nominal bonds are available, aggressive long-term investors should hold stocks, while conservative ones should hold primarily long-term nominal bonds along with small quantities of stocks.14 These results support the conventional wisdom about optimal portfolio choice for long-term investors.
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Bond Demand in the Presence of Equities

The realism of the preceding analysis is limited by the fact that we have not allowed investors to hold equities. We now consider a scenario in which both bonds and equities are available to the investor. Table 8 reports optimal demands for equities and for 10-year indexed or nominal bonds by investors who are unconstrained (in panel A) or subject to borrowing and short-sales constraints (in panel B). For simplicity we do not allow investors to hold equities and both types of long-term bonds simultaneously.
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In a world with full indexation, the unconstrained demand for both long-term indexed bonds and equities is positive and often above 100%, implying that the investor optimally borrows to finance purchases of equities and indexed bonds. The portfolio share of indexed bonds exceeds that of equities, despite the higher Sharpe ratio of equities, because indexed bonds are much less risky than equities. As the coefficient of relative risk aversion increases, the demands for both long-term indexed bonds and equities fall, but the share of equities falls faster.

In th...

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Comparing the first two panels of Table 7, we see that bond indexation can have substantial benefits to investors. Investors with low risk aversion benefit because indexed bonds have higher Sharpe ratios than nominal bonds, while more conservative investors benefit because indexation eliminates an unwelcome source of risk. The effects on welfare can be substantial; when their portfolio choice is unconstrained, for many investors the value function is more than twice as high in a fully indexed environment than in a purely nominal environment. Such investors would be willing to pay more than half their wealth to enjoy the benefits of indexation. The only investors who lose from indexation are investors with low risk aversion who are subject to borrowing and short-sales constraints. These investors prefer to hold nominal bonds, despite their low Sharpe ratios, as a way to increase risk and expected return without using leverage.
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These findings are in strong contrast with the claim of Viard (1993) that indexation has only minor welfare effects. Viard models indexation as elimination of the inflation risk in a one-period asset, and studies the benefits to one-period investors. Since there is little risk in inflation over one period, Viard’s result is not surprising. We get much larger benefits of indexation because we model indexation as elimination of the inflation risk in long-term assets, and study the benefits to long-term investors.

An a...

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