The Hindu Business Line : London: A financial system in trouble

There has been widespread concern over the hit in the credibility of the UK’s financial regulatory and supervisory system, as reflected in the case of the Northern Rock. In this context, it behoves us to ask whether the Government of India would do right to adopt the FSA model as a paradigm shift for India, says S. VENKITARAMANAN.

I have been particularly struck by events of the last month in the financial circles of the UK, with special reference to the near collapse of a mortgage lending bank. The reflections on this are prompted by the fact that our fixation with things British is illustrated by Percy S. Mistry’s report on making Mumbai an International Financial Centre.

For Percy Mistry, the Chairman of the High-powered Experts Committee, most things British are worth copying, albeit with Indian adaptation. We have to critically review this in the background of what happened in Britain recently.

The British financial press has been agog on the various goings-on in the financial system, especially the Bank of England, the FSA and the Treasury. It has been particularly concerned with the Governor Merwyn King’s so-called changes of stance in dealing with the crisis in the Northern Rock.

A comparatively small bank, the mortgage lender based in New Castle used to borrow in the money market — the inter-bank market — and lend against mortgages. With increasing trouble in the mortgage market, the bank was in distress. The inter-bank lenders froze up and the bank had to approach the central bank for help.

Unexpected reaction

The Bank of England made a well-intended announcement that it would stand by the stricken Bank. But that very announcement had an unexpected (?) perverse impact. Depositors became concerned about the bank’s creditworthiness once it approached the Bank of England. Queues started forming outside the bank’s various branches for depositors to withdraw their moneys. The newspapers were quick to point out that this was the first bank run in Britain since 1866. Britain was also the first major economy where the credit crunch arising from the sub-prime had spilled out on the streets.

The crisis called for fresh initiatives from all concerned. The Governor of the Bank of England made a brave statement that funding such banks, which had taken undue risks, would be tantamount to “sowing the seeds of future crises”, since it would amount to rewarding risk-takers.

Shortly after this, the Governor changed his stand and announced his willingness to lend funds to Northern Rock against even mortgage securities — a step, which, if taken earlier, would have prevented the very crisis at Northern Rock. On top of all this, the Chancellor of the Exchequer stepped in and came out with a tax-payer-backed guarantee of the deposits of Northern Rock — obviously a politician’s response.

‘FSA asleep at the wheel’

All this would be treated as a storm in a tea cup — after all, it is a relatively small bank that is involved. But the defects that this episode brings out in the British system are worth examining, especially since the crisis is the first after the Gordon Brown Reforms a decade ago, which stripped the Bank of England of its supervisory jurisdiction and installed the Financial Services Authority (FSA) as a single regulator and supervisor of banks, insurance and stock markets.

This episode is particularly instructive since observers of the incidents, a la Northern Rock, have been quick to acknowledge that the FSA was asleep at the wheel. The new British system lacks a single point of responsibility, which had been there when the Bank of England, the lender of last resort, was also the supervisor and regulator of the banking system.

Further, the fact that central banks around the world were warning of a tightening of credit and of weakness in the housing sector makes us wonder why the FSA failed to caution Northern Rock against risky lending ways. In my view, the Governor of the Bank of England has nothing to be apologetic about. It is the system change that failed Britain.

Not for India

This discussion is particularly appropriate in the context of the recommendation of the Percy Mistry Committee on making Mumbai an International Financial Centre. That Committee goes overboard on the advantages of a single regulator on the lines of Britain’s FSA. In its view, the chances of Mumbai becoming an International Financial Centre would be brighter, given a credible regulator and supervisor, a la the British FSA.

In the Northern Rock episode, the very system the Mistry Committee seeks to impose on India has failed. The signs of impending crisis were ignored by the British FSA, in spite of warnings by all global central banks.

The provision of an FSA cannot be a single-point remedy to Percy Mistry’s perceived ills of India’s financial system. Better that we correct the errors and shortcomings within the RBI’s own existing supervisory and regulatory system rather than recreate a whole new regulatory system with multiple responsibilities.

British media are concerned over the hit in the credibility of the country’s financial regulatory and supervisory system, as displayed in the case of Northern Rock.

If Britain prides itself on anything in matters financial, it is on the integrity of its financial system, its innovations and sustainability. Not for nothing did London offer a stiff competition to New York in financial services.

Unfortunately, the latest episode leaves some of the sheen tarnished. It is not a question of whether Merwyn King changed his mind once too often or whether the Chancellor did the right thing in throwing tax-payers’ money to back a derelict banker. It is more a question of system design that is to be faulted.

‘If not broken, don’t mend it’

In the light of all this, it behoves us to ask whether the Government of India would do right to adopt that part of the Percy Mistry Committee’s recommendation that lays down the FSA model as a paradigm shift for India.

There are undoubtedly certain advantages in the FSA model, but there are also risks as Northern Rock shows. It is worth the Government’s and the RBI’s consideration whether a change of system as radical as the FSA is needed when at its first test it has failed in the UK.

There are other aspects that the Northern Rock episode discloses that can be studied in the light of the Indian environment.

The fact remains that the RBI still stands high on the roster of credibility. It does not appear that the Government of India will overrule the RBI in matters such as lending tax-payer backed support to a failed bank.

In the one case that I know, the Bank of Karad, the RBI resorted to liquidation rather than lending money to a failed bank. Many other instances show how the Government of India and the RBI have been models of financial prudence compared to what the British system has now displayed in the Northern Rock episode.

The above reflections on the failure of a bank in UK would not have been worth the while except for the fact that the High Level Committee report on making Mumbai an International Financial Centre is being seriously considered by Delhi. By all means, let us accept the report where it makes sense. But when it suggests radical changes in a supervisory and regulatory system, let us respect the old American adage: “If it is not broken, don’t mend it”.

The Indian system is not broken. Let us keep up India’s proud record of stability by not attempting to change it too radically.

Establishing Mumbai as an International Financial Centre is not worth the while if it involves a radical system change that will arise from the Percy Mistry Committee recommendations. The game is not worth the risks it involves!

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