The Hindu Business Line : Central bankers are fallible

A debate is on whether central bankers may have themselves been responsible for the problems that led to the sub-prime mess in the first instance and whether their subsequent actions are over-compensating. Be that as it may, the debacle has hopefully been a testing ground from which the world’s central bankers have emerged stronger, says S. VENKITARAMANAN.

In handling the latest episode of financial turbulence in global markets, certain unusual decisions of central banks have come in for criticism. These include the US Fed pumping in extra liquidity to bail out banks. So too, in the European Union, following the sub-prime crash of a lender. Neither of these actions is unusual, but they invited criticisms of moral hazard.

While the immediate justification for these actions varied from country to country, the motive was the same — to keep the financial markets from seizing up. Particularly since the financial markets in the US are the life-blood of the economy, the gesture of the Federal Reserve had the necessary and intended salutary effect. It restored the temper of the markets and let the juice flow to keep the economy ticking.

It is not clear whether, in the aftermath of events, Dr Reddy would have faulted his peers — the central banks of the US and the EU — for what they did in either cases. The proof of the pudding is in the eating, the outcome of the action. What the Bank of England did or did not do with regard to Northern Rock, a mortgage bank, was, of course, different.

Overcompensating?

In the context of all this, a debate has ensued as to whether central bankers may have themselves been responsible for the problems that led to the sub-prime mess in the first instance, and whether their subsequent actions are over-compensating. In one view, the loosening of rates in the past decade laid the seeds for future trouble in the sector. It is, of course, true that the encouragement of sub-prime lending scenario also paved the way for widespread ownership of houses in the US than would otherwise have been possible. That is, however, no excuse for the lack of supervision of sub-prime lending. This got into trouble when the interest rates were adjusted upwards, as inevitably happened after a benign interest regime.

More egregious was the failure of the British analogue of the central bank, the Financial Services Authority, which supervised — or did not adequately supervise — the misdemeanours of mortgage lender Northern Rock, which borrowed in the short end of the market and lent long to house-owners. The bank’s collapse led to a serious banking crisis, the first of its kind in many decades in the UK.

All this exposed the fallibility of central bankers and their equivalents, who had attained the status of dominant, almost infallible, denizens of the financial scene, following the reformist trends of the 1980s and 1990s, which saw the paramountcy of central bank independence. This was partly the result of the dominance of the monetarist school, which saw Governments as unnecessary intruders in economic policy and sought to substitute independent policy-making by central bankers at the centre of economic decision-making in nations, both rich and poor.

Particularly central to this evolution was the emergence of inflation targeting as the goal of central bankers. True, the inflation fighters in the galaxy of central bankers have performed well in spite of successive phases of crude oil price increases.

Inflation has been kept benign, by and large, and growth maintained globally. All this took place almost without interruption and brought glory to central bankers till the sub-prime mess overpowered them. Central bankers were caught on the horns of a dilemma. If they loosened their controls more, they would risk further trouble. If they tightened controls, they would risk the prospect of economic growth and of jobs. They were caught between Scylla and Charybdis.

Issue of propriety

Questions have been raised about the propriety of some measures supported by central bankers, particularly in rich countries. One such is the $75-billion hyper fund to be set up by a number of major US banks, which will ‘bail out’ distressed sup-prime assets.

The criticism advanced against the hyper fund is that it is subject to moral hazard — encouraging future risk-taking lenders to expect a similar rescue operation. Ultimately, the hyper fund will also have backing by Government. This means US tax-payers’ money will be used to salvage risky lenders who pursued profits.

This measure has been primarily the brainchild of the Secretary of the Treasury, but the Fed has no less a role than the Treasury. It may be recalled that such bail-outs had been frowned on by US economists and policy-makers in the aftermath of the Asian crisis in the 1990s, especially advising developing countries to stay off the slippery path. But when central bankers themselves lead bail-outs, what are we to say?

This reminds me of a famous anecdote about the legendary central banker Paul Volcker, who was reportedly approached by a friendly CEO of a bank asking what he would say if he, the banker, asked him (Volcker) for a bail-out. Volcker’s reported reply was “You will have to ask my successor”. Volcker was, of course, sardonically referring to the fact that he would quit rather than hand over a bail-out. Central bankers have changed since then. They have come to accept bail-outs as the order of the day.

Role of rating agencies

Among outstanding issues arising from the recent financial turbulence is the role and regulation of rating agencies and securitisation, which played no small role in the origin and evolution of the mess! Rating agencies have been rightly faulted for many failures. To regulate rating agencies, however, is a challenge. One option is for the Government itself to regulate rating agencies. It seems, however, better that an agency such as the securities regulator takes on this role so far as securitisation is concerned — the US proved itself on innovation.

Turning to securitisation, it was very much a product of this rush to innovate. The challenge before central bankers is to control and regulate securitisation without hurting the beneficial outcomes of increased flexibility, which securitisation reportedly gives. Care has to be taken to see that mathematical models, by their overuse, do not throw prudence out of the window.

A continuing challenge for central bankers is their having to handle the problem of hedge funds and private equity players. There are large pods of private funds owned by high net-worth individuals and financial institutions. They are, however, opaque in an extreme sense.

The US regulatory system does not seem to be too willing to regulate hedge funds, although some law-makers are keen. (Incidentally, SEBI’s revised regulations regarding Participatory Notes suffer from the infirmity that to the extent that they allow only regulated entities to come in via that route, hedge funds are ruled out. Virtually, the bulk of Participatory Notes may be hit, if they owe their resources to hedge funds, which have no regulator.)

Others’ experience

In the struggle between financial stability and growth, the central bankers of the world continue to have a vital role to play. Recent encounters with near-collapse of the system in some countries may have taught them many weighty lessons. Let it not be said, however, that central bankers of countries such as India, who are not exposed to the sub-prime episode, cock a snook at the performance of their peers in countries so exposed.

One lives and learns in the school of others’ experience. If one does not so learn, one is condemned to repeat those follies. The sub-prime mess has been a testing ground — a school — for central bankers of the world. Hopefully, they have emerged stronger from the ordeal of fire.

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