The Hindu Business Line : Averting the sub-prime crisis

If the economy has staved off sub-prime contagion so far, it is in large part due to the systems assiduously put in place by the RBI, especially with regard to derivatives transactions and self-regulation. One hopes the country will continue with gradualism in financial sector reforms and not throw caution to the winds, says K. SUBRAMANIAN.

On August 10, when the sub-prime crisis turned into a global contagion, central banks across the world went into a huddle and injected $120 billion to restore confidence in financial markets. They offered liquidity on tap. The European Central Bank (ECB) took the lead and the US Federal Reserve (the Fed) which, for long, remained confident over the ability of the market to correct itself, had no other recourse. Others in Asia, such as Japan, Singapore, Australia and New Z ealand, followed suit.

To date, the nature and ramifications of the malaise have not been fully assessed. More and more analyses are pouring out of the pink papers. Most agree that the villain of the piece was the collateralised debt obligations (CDO), which had been bundled, traded or leveraged without the players even knowing the true value of the bundles. CDOs have proved to be snakes in the grass and one will never know who the next victim will be.

Viewed against the nature of the virus, which is very different from what the world had seen earlier, there are debates about the legitimacy of intervention by central banks. Prof Paul de Grauwe, of the University of Leuven, argues: “ECB bail-out sows seeds of crisis” (Financial Times, August 12, 2007). Intervention intensifies moral hazard and bails out hedge funds that avoided supervision by central banks — the price ordinary banks have to pay for such distress cover. Reports clearly indicate that the Fed intervention has failed to calm the market nerves so far and there is flight to safety in Treasuries. This has intensified pressure to cut the Fed rate.

After a crucial meeting on Tuesday (August 21), there are reports that the Fed chief, Mr Ben Bernanke is “absolutely” prepared to use “all the tools at his disposal” to address the crisis. The US Treasury Secretary, Mr Henry Paulson, is “pressing his staff to think whether there is anything creative the Treasury Department can do to help ameliorate the market turmoil and reduce chance of it causing serious harm to the real economy.” He is said to be in regular contact with Mr Bernanke, discussing the developments. Sadly, all central banks are groping in the dark and have no clue about their next step. Not so the Reserve Bank of India (RBI).

No sub-prime baggage

The RBI may be watching these developments with satisfaction, if not pride. Our banks are not impacted by sub-prime baggage. The expectation was that banks with foreign branches might be exposed. This is not so. The reported exposure of banks are: ICICI: $1.5 billion; SBI: $900 million; Bank of India: $440 million; and Axis Bank (formerly UTI): $150 million. These cover credit default swaps (CDS) and credit-linked notes issued by Indian companies. They are not tainted by toxic waste. How did this situation come about?

It is instructive to have an idea of the steps taken by the RBI in developing the derivatives market in the country. Indeed, it is a part of the gradual process of financial reforms and liberalisation. In its efforts, the RBI had to contend with the zeal of bankers, private traders and pro-reformers, who lobbied for faster reforms. There were also demands for the industry adopting the model of self-regulation, as in some other countries. The RBI resisted these and was reviled by critics.

An internal working group reviewed the existing guidelines on derivatives and formulated comprehensive guidelines for banks, taking into account the growing complexity, diversity and volume of derivatives used in banks. Final guidelines were issued on April 20, 2007, after getting feedback from banks and the public. The approach was captured in the Annual Monetary and Credit Policy 2007-08 thus: “As part of the gradual process of financial sector liberalisation in India, it is considered appropriate to introduce credit derivatives in a calibrated manner at this juncture.”

This was based on the RBI’s confidence that the risk management architecture of our banks had strengthened and they could manage the products prudently. The RBI Act of 1934 was also amended to empower the RBI as the nodal agency to regulate over-the-counter (OTC) derivatives. The RBI, in turn, has put in place a framework for oversight of financial conglomerates, along with SEBI and IRDA. This situation does not hold good in any other country. Not even the US.

Ms Shyamala Gopinath, Deputy Governor, RBI, covered the issues succinctly in a lecture delivered on September 27, 2006 in Mumbai. For the RBI, the rapid proliferation of derivatives exposures was a challenge on account of the downside risks associated with them, if not managed properly. “There are issues relating to use of structured products, valuation, counterparty-related issues, risk management and reporting issues” and the need for skill development among bank executives.

Gradualist approach

It was recognised that: “While derivatives facilitate risk hedging and risk transfer to institutions more willing to bear the risks, the tendency of participants to use derivatives to assume excessive leverage and lack of prudential accounting are matters of concern.”

While introducing derivatives modes, the RBI took care to ensure that all transactions are held in the books or balance-sheets of banks, with due accounting values. It did not the permit what are called off-balance-sheet (OBS) transactions, endemic among foreign banks. These OBS ghosts have ravaged those banks flaunting OBS accounts.

Further, under this derivatives regime, synthetic products are not permitted. It limits the range of CDS to instruments where the reference entity is a single entity. The contracts traded are required to be determined and settled in Indian rupees. There is also the caveat that foreign institutional investors (FIIs) maintain either cash or sovereign securities as collateral for trading in derivatives.

If the country averted the sub-prime contagion, we owe it to this system put in place by the RBI assiduously. If capital control had saved India from the Asian flu of 1997, the gradualist approach of the RBI in shaping the derivatives market averted the sub-prime contagion entering our shores.

Stock market not immune

This may not be said of the stock market, which has been buffeted by the operations of FIIs. The sell-off in the stock market, until last week, marked the eighth correction that interrupted the Sensex’s four-year rally. Asian markets, as a whole, have hit the lowest levels. The reasons are not far to seek.

It is known that hedge funds operate indirectly through partnership notes (PNs), and 80 per cent of them operate at their behest. When these funds face a credit crunch, they withdraw liquid assets held abroad. No wonder FIIs have been net sellers ever since the crisis set in. This volatility could have been avoided if PNs had not been given a free hand. Unfortunately, this is an area where the policy divide between the government and the RBI persists.

Surprisingly, there are reports that the government has decided to allow hedge funds to register directly as FIIs instead of adopting the PN route as at present. SEBI seems to have been consulted. And the Finance Ministry anticipates dissent from the RBI.

One hopes the government will not throw caution to the wind and pursue this measure if the present global crisis triggered by hedge funds provides any lessons. Even advanced countries such as the US and many European nations, which were somewhat kid-glove-ish in their handling of hedge funds, have been chastened and are reviewing their future role in this area.

(The author, a former Finance Ministry official, has experience in international, financial and trade issues.)

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