The Hindu Business Line : Lessons from US crisis

The crisis is leading to fears that the US credit market may reach a gridlock and the country itself may be facing a recession due to shortage of credit, since banks have problems raising further funds. The problem has spread to European banks as well.

The collapse of the titans of Wall Street should open our eyes to the potential potholes in the road ahead. Universal banking can be a glamorous model, but it has its risks.

S. Venkitaramanan

The sub-prime crisis has taken a heavy toll on banks around the world. US banks have been most vulnerable since sub-prime house loans rose to high levels in the US in the last few years. Banks lent more and more to sub-prime house owners, aided and abetted by the liberal flow of funds from Wall Street investment banks, which sold these loans in securitised packages to investors, who were tempted by the above par interest rates yielded by the loans.

The banks soon came to realise that the sub-prime loans had more than expected default rates and underwent heavy losses. The investment banks have also taken a heavy hit. The crisis is leading to fears that the US credit market may face a gridlock and the US itself may be facing a recession due to shortage of credit, since banks have problems raising further funds. The problem has spread to European banks as well, taking down even the venerable UBS.

Assessing losses

The magnitude of losses faced by US banks and other developed country institutions is still being assessed. Analysts of Goldman Sachs — which incidentally has come out unscathed — estimate that the losses may run into hundreds of billions of dollars, especially when the third quarter results of banks and institutions are unveiled.

The Citibank group itself has disclosed losses of as much as $8-9 billion . Some estimates coming in from respectable bank analysts pitch possible losses at as high as $50 billion. The losses are, indeed, heavy.

There were also similar crippling losses at Bear Stearns, the investment bank, and the leader of bulls, Merrill Lynch, again in billions of dollars. The CEOs lost their jobs, although in typical American fashion, they were paid handsome retirement bonuses running into millions of dollars.

Going about it differently

The media has been running a series of exposés on the behaviour of these banks. Fortune wrote a derisive article entitled “What were they smoking?” But, by and large, the Americans have been relatively relaxed about the manner in which the system has dealt with the chiefs of banks. It perhaps speaks of the tolerance and maturity of the American business system that it takes both risk and reward in a calm and composed manner.

Not for them the hoopla of CBI or FBI investigations or FBI experts or non-experts raiding CEOs’ houses and offices, subjecting them to public humiliation and condemning the system to a fear of taking any decision. Nor has there been a call for a Joint Parliamentary or Congressional Committee comprising non-expert Members of Parliament or Congress treating the country to a spectacle of a Roman circus, shooting questions on how and why a particular banker took or did not take a lending decision. Much heat and not much light came out of our own Parliamentary enquiries.

Unlike in the Indian case, there was no accusing finger pointed at the bank supervisor — the central bank, in the American case. Questions were not raised as to what the central bank was doing when the banks were lending. The public at large was aware that it is the banker’s job to manage his loans and investments, a supervisor can only lay down guidelines and prudential norms and inspect from time to time. It cannot be expected to micromanage banks — which is what some members of the Indian political class expected in 1991.

True, some questions were raised in the US about the Federal Reserve’s benign interest policy, which had allegedly led to loans being disbursed too liberally. But that was considered a central banker’s privilege — whether to raise or lower interest rates.

Conglomerate model

A more material aspect of the US banking debate, which is threatening a global recession, is how valid is the US conglomerate banking model, on which India and other developing countries, barring China, are shaping their banking system.

Citibank, for example, became a massive conglomerate employing nearly 3,00,000 people, with an insurance wing and investment bank and private equity arms. True, it grew through many acquisitions in Sandy Weill’s days. The latest CEO, Chuck Prince, who has now quit, tried to cut down the number of businesses.

Whether a universal bank model, such as Citibank, is managerially the optimal one is being hotly debated. Analysts are arguing that Citibank has become too much of a massive conglomerate for the top to manage. Calls are out for breaking it up. Arguments will, no doubt, be found for keeping it whole.

But the warning signals are there for Indian banks to read. Should we go the same way? Or should we try to manage complexity better in the under-served financial scenario in India?

There are doubtless advantages to the universal banking model. A bank, which lends money to its customers, gains access to a large market for selling insurance, mutual fund products and investment advice.

There is synergy between the different operations. So, the logic for selling insurance, credit card, mutual fund under the same umbrella! But management has to be appropriately strengthened. Supervision also has to be discrete and separately organised.

An important question raised in this context is whether Basle-II norms were themselves responsible, to some extent, for banks resorting to special purpose vehicle housing securitised assets formed out of their loans.

In one sense, this point of view gains support from the fact that banks, which securitise loans and take them off their balance sheets, require that much less capital. But Basle-II norms also put rating agencies in the centre of the risk computation.

Rating agencies have been criticised for their role in assessing the riskiness of securitised packages of sub-prime loans, which were sold to investors.

But the extent to which securitisation distances the originators — the lenders — from the packages that are sold to investors is a telling point in the criticism that Basle-II norms have been partly responsible for the latest crisis.

Once lenders sell off their securitised packages to investors, they stop taking care about the performance of their borrowers — or so it has turned out. This is partly the result of the way in which the American investment banks used securitisation. But we have to ensure that the model gets the full impact of continued monitoring of the loans disbursed even after they are packaged and sold.

Potential potholes

The collapse of the titans of Wall Street, the heavy losses that have hurt the bankers of the US and Europe, should open our eyes to the potential potholes in the road ahead. Universal banking can be a glamorous model, but it has its risks.

Securitisation may look like an easy way out of Basle-II norms, but it can lead to disaster unless the loans securitised are continually followed up. True, supervisors cannot shirk their responsibilities. But the overall responsibility remains squarely on the lender to ensure that the loans are properly disbursed and monitored, investments are properly accounted for.

After all, the banker has a heavy responsibility. Millions trust their savings to him or her.

The way Citibank’s Chuck Prince or Merrill Lynch’s O’Neil has gone is standing warning to the chiefs of all financial institutions around the world. They have to take risks, but not too much, seems to be the abiding lesson. Otherwise, they may risk not only their jobs and their banks but also the national economy.

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