The ongoing financial crisis in the U.S. has plenty of messages for developing countries. Unlike in the U.S. where faith in the markets remains, India has never been averse to state intervention.
The ‘once in a generation’ financial crisis in the U.S. has many lessons for India and other developing economies. First, the role of the U.S. regulators and the changes that will be made are subjects of interest to us.
Second, the extent to which our financial sector and the economy will be affected by the crisis in the U.S. Finally, the likely impression in India of the U.S. financial sector long after the end of the crisis.Complex instruments
The role of regulators has already come under intense scrutiny. Some economists say the easy money policy followed by the U.S. Federal Reserve under Alan Greenspan spawned the crisis. Banks took advantage of the liquidity and fashioned innovative financial instruments, incorporating housing mortgages, among others, that could then be easily sold to investors. In one sense, therefore, the regulators might have done a service.
People who could not afford homes were enabled to buy them by banks which provided the money. Such sub-prime loans might have assumed menacing proportions. However, banks thought that the risks inherent in loans to the less creditworthy could somehow be minimised and taken off their balance sheets. The individual loans were securitised and packaged into highly complex instruments such as collateralised debt obligations (CDOs).These instruments put together with the help of wizards in mathematics and physics became incomprehensible to the banks and institutions which dealt with them. Neither their investors nor the rating agencies could divine the risks. It is this complexity that truly defines the financial crisis. It is too much to expect the regulators to be one up on the financial market that seemed to thrive on such complexity.New plans
New plans to overhaul the regulatory apparatus have been proposed by the U.S. Treasury Secretary. Under these, the Securities Exchange Commission (SEC) will become some kind of a super regulator. Financial intermediaries such as hedge funds that have so far remained outside regulation will be brought into the fold. The Federal Reserve will be responsible for market stability. A major overhaul on these lines — the most sweeping after the Great Depression of the 1930s — will naturally require time to be debated, modified wherever necessary and then adopted. Surprisingly, for all that has happened, the proposed changes are still based on the premise that regulation can never be a substitute for market discipline.
This assumption has already drawn plenty of criticism. There has been no evidence whatsoever of markets providing the required checks and balances. None of the institutions involved in large scale excesses have been punished by the markets.
On the contrary, regulators and the government had to step in to save Bear Stearns in the U.S. and Northrock in the U.K. They did this in order to prevent a systemic crisis. Failure of the two institutions would have had a domino effect and led to a serious erosion of investor confidence.
In India only the very naive believe that the market will act as an umpire.Indian banks’ woes
There is so far no indication that Indian banks have lent en masse to borrowers with low credit standing.(Sub-prime in India refers to a category of borrowers who enjoy a high rating and are consequently able to pressure the government banks into giving loans at below prime rates.) Yet a degree of recklessness on the part of private banks in lending to home and retail segments has been evident.
The Reserve Bank of India has been cautioning these banks and has made lending to some of these sectors more expensive.
While ICICI Bank has provided for possible loss arising out of its overseas investment in some of these complex instruments, other Indian banks have not been forthcoming so far. But a bigger worry is likely to emanate.
Of course, the Indian financial sector, comprising the stock exchanges, banks and NBFCs, is affected by the global turmoil. Liquidity is drying up and risks are getting repriced.
Again, Indian banks may not have deliberately introduced complexity nor indulged in financial engineering on a large scale. Yet the ongoing standoff between some banks and client companies over derivatives suggests that the Indian financial sector may not after all be free from such practices. Confusing new products
Second, certain new products such as the equity-linked debentures offered as portfolio schemes and capital protection mutual funds do need to be explained more lucidly. These are becoming popular among high net worth individuals.
Portfolio managers generally fix a minimum of Rs. 10 lakh for investing in equity-linked debentures.
Despite its nomenclature (which connotes a fixed income) this form of debenture is bench marked against popular stock indices such as the Nifty. In effect the returns from the debenture depend on how well the portfolio manager reads the stock price movements.
Third, complexity is a relative term. In the hands of untrained bank staff even the simplest product can appear to be complex.
Financial education normally means educating customers, both existing and prospective. But at this stage of their development private banks need to invest far more in equipping their staff to guide their customers in the conduct of even the most basic of products and services.
Finally, the ongoing financial crisis in the U.S. ought to remind us once again that the biggest banks and institutions in the world, many of them with a large presence in India, are not infallible. They might have used super computers and employed rocket scientists but they have ended up with products and services of which they seem to know little.