The Hindu Business Line : Learnings from the financial crisis

Let not the experience of the sub-prime crisis lead the RBI to put blocks in the way of adequate credit growth in the Indian economy, provided it is for the right purposes, properly supervised and monitored. The role of the RBI has to be to nurture growth as well as stability. That is the abiding lesson that one takes away from the sub-prime crisis, says S. VENKITARAMANAN.

The sub-prime crisis has come and gone, hurting the financial markets and wiping out billions of dollars from the wealth — albeit on paper — of individuals and corporates. The widespread casualties of investors, including hedge funds and investment banks, have provoked a number of reflections among analysts around the globe.

The good news is that with all the contagion, the Indian real economy has not been affected as adversely as the South-East Asian economies were affected in the aftermath of the contagion following the Asian crisis a decade ago. Perhaps, this is because the crisis was primarily centred in the more mature markets of the world — the US, Europe and Japan. The central banks were also prompt in stepping in with infusion of liquidity and even rate cuts. What are the abiding lessons that we can take away from the crisis?

That the crisis arose in the mortgage markets of the US and was fed by financial innovations, such as securitisation, is an aspect that should be a wake-up call for all economies. In Indian mortgage markets, there has been less of a tendency to indulge in excesses of the kind that US markets engaged in.

The Indian housing lender is, by and large, more cautious and does not strive to take on the sub-prime markets, although in the pursuit of inclusive banking, there have been suggestions to banks to search out those below the poverty line for lending. While we have gone some extent in encouraging loans on limited documentation, the stress of looking for persons without a known income or job is not there.

One lesson of the sub-prime crisis is that we should be cautious and prudent even in our pursuit of growing the housing loan book. The National Housing Bank is the official regulator of housing lending in India.

Hopefully, it will learn the right lessons in regulating the housing loan activity of our aggressive lenders. The lenders should not resort to unconventional and imprudent offers of too attractive terms of interest and repayment.

One of the wrong lessons that could be learnt from the sub-prime episode is about securitisation. Securitisation of loans has developed over the last decade in India. This is a device that enables the lender to create securities out of its loan assets and sell it to willing investors. These assets get off the balance sheet, releasing that proportionate share of capital for fresh lending. The investor in the securitised assets gets hold of assets with good returns. The risk is transferred from the lender to the investor.

The securitisation of loans in India is covered by a number of rigorous guidelines. The fact that the sub-prime bust originated in securitised loans should not induce further restrictions on this. It is a useful innovation and the RBI rules should take care not to scare it away totally.

Securitisation is a good tool to be carefully used. Let not the RBI make the rules too strict. It is more important to ensure that the originator of the loan practises the appropriate procedures of lending — adequate security and monitoring of repayments in time.

One of the primary reasons for the sub-prime mess in the US was the entry of investment banks, which indulged in sophisticated bundling of securitised assets. That, in itself, is not a bad thing, provided the investors take good care o f the underlying assets and their creditworthiness. Here is where the rating agencies come in. Unfortunately, the rating agencies have been unregulated so far. Their record in this latest crisis, as in the Asian crisis, has been clouded by a number of missteps.

I know it will be said in defence of rating agencies that their analysis is based on transparent criteria and they should not be blamed for failing to forecast how the default rate would rise. The jury is still out on this.

So far as Indian rating agencies are concerned, they are professionally managed and are adopting best practices. Maybe, there is need to be a bit more transparent about their analysis. There is also need to evaluate how good rating agencies are at anticipating likely troubles. True, rating agencies serve a useful economic purpose and should be regulated in the best manner, following international best practices.

The hue and cry against hedge funds in the aftermath of the crisis partakes of the usual envy factor. Hedge funds and their managers profit hugely from the fluctuations of the financial market place. They have a place in the evolving a rchitecture of finance. After all, those who invest in them seek higher returns and are prepared to take greater risk. Hedge funds from abroad are known to invest in Indian paper.

It is not appropriate to take strong action against hedge funds in general just because a few of them invested in sub-prime securities. They do so in a lot of other securities as well. We will be committing a mistake if we ban access to hedge funds because of a feeling that they had benefited from the sub-prime security market. They also include a number of hedge funds that were wiped out. We will do well to follow what the SEC of the US does in regard to hedge funds in general.

The danger of the sub-prime crisis has been such that central banks, including the Fed and ECB, thought it appropriate to invest in injection of liquidity to cushion the shocks to the markets. However, the central banks, as a class, sh ould not react aggressively by discouraging credit growth in general. This is critical to the achievement of our targets of GDP growth.

There is one more aspect of central bank behaviour that one learns from the recent sub-prime experience. One of the causes of the crisis was the rapid increases in interest rates by the US Fed, which, in turn, led to sub-prime borrowe rs finding it impossible to maintain repayments on adjustable rate mortgages as the rate was reset from time to time. This is partly because in their inflation fighting role, central banks tend not to take into account established borrowers who are locked into floating rates.

While fighting inflation is all to the good, it should not be a fight to the finish — to finish off all borrowers. Some safeguards are needed to ensure that the unfortunate many who are linked to flexible rates are protected from unanticipated consequences. Perhaps, this requires a careful review of both inflation-fighting tendencies.

Above all, the RBI needs to take action to ensure that lending practices are properly documented, supervised and not lost in competitive pressure. Securitisation itself should be encouraged, but with carefully-crafted guidelines.

The rate of growth of credit should not be reduced out of fear of runaway increase in borrowals. The role of the RBI has to be to nurture growth as well as stability. That is the abiding lesson that one takes away from the sub-prime crisis.

Related Stories:
Rating agencies: Fence eating the crop?
Global financial crisis: ‘A lot more is yet to come’
Pains from the sub-prime fiasco

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