The Hindu Business Line : Global financial sector needs closer scrutiny

The French Bank, Societe Generale… Just as individual rogue traders can upset a bank, a sleeping government can cause problems for the rest of the world.

C. Gopinath

It was amazing to read, last week, that Jerome Kerviel, an employee of the French Bank, Societe Generale, used his inside knowledge of the systems and procedures to place bets that ended up with losing the bank about $7.2 billion (Rs 28,289 crore). He was a trader in the bank, but hacked into computers and altered controls, took unauthorised bets, placed fictitious counter-trades, and so on.

To lose this kind of money, he must have placed bets of at least ten times that amount. This is the largest amount of fraud that any bank has experienced to date. The previous such rogue operations were in the not-too-distant past. Nick Leeson lost $1.4 billion (Rs 5,500 crore) and ended up causing the collapse of his bank, Barings. And Yasuo Hamanaka, a trader at Sumitomo lost his employer over $2.6 billion (Rs 10,215 crore).

These are examples of individuals who exceeded authority, manipulated rules, concealed information, and committed outright fraud. I’m sure they defend themselves that it was all a mistake, how they initially tried to make money for the bank, something went wrong, and when they tried to cover it up, more went wrong. They were rightly led away in handcuffs, and while their employers and other banks would have gone back to re-check and tighten procedures, I doubt if an evil mind can be completely deterred.

You don’t even need an evil mind to generate losses in trading activities. Most trading operations of financial institutions suffer from a moral hazard problem; traders are paid enormous bonuses for the profits they make but are hardly penalised for losses in the process. Thus, when they make a large loss, there is no incentive to stop, but enough incentive to continue making large bets in the hope of compensating and coming out ahead.

Failure of controls

Can we lead away, in handcuffs, the financial leaders and regulators of a nation, when they make mistakes, and cause losses for individuals and nations around the world? That would be tough, but we wish we could. Jean-Claude Trichet, the head of the European Central Bank, pointed his finger at the US for bad financial management that has led to the current credit problems around the world.

There were two problems that he identified. One was the disaster (US press prefers to call it a crisis) that arose from the mounting bank losses due to sub-prime mortgage loans being given out by US banks. Beginning last summer, many banks have been announcing, one by one, how they have problems on their balance-sheets because of exposure to these mortgages.

It is a failure at the level of the institution, much like the failure at the three banks with rogue traders referred to earlier, because it reveals a breakdown of risk controls at the bank.

When banks threw prudent practices to the winds and began lending to people of high risk, or began unsavoury marketing practices to convince people, who would otherwise not qualify, that they did qualify and thrust loans down their throats, it is again a failure of controls in the bank.

Trichet’s second problem with the US was that the regulatory authorities did nothing about it, a failure again of controls at the level of the nation. Apart from poor supervision of banks and other financial institutions, the US Federal Reserve (central bank) has laid itself open to the charge that it let interest rates remain low for too long, fuelling risky behaviour by the banks. Easy loans fuelled by what was a growing bubble in the housing market set the stage for the mortgage disaster today.

Mortgage disaster

The problem with finance these days, whether it is at the level of the country, or an institution like a bank, is that they are too closely intertwined with other nations around the world. We saw that first at the time of the 1997 financial crisis that began with Thailand and spread through Russia, Brazil, Argentina, and so on, to end up in the US. Global linkages have only been getting tighter.

The US exported its problems and disaster in the sub prime mortgage market by the neat trick of securitisation. A few clever financial institutions came up with the idea. The mortgages were broken up, bundled up, combined with other loans, treated as new securities backed up by the mortgages, and sold around the world.

The new instruments, called collaterised debt obligations, were so complicated that the regulators did not know how to calculate the risk of these instruments and relied on those who originated these products to calculate the risk! Many finance managers of towns and companies who invested in them did not know what they meant.

Banks everywhere now realise that they are holding a piece of US’ problem, and the virus has spread to municipal and mortgage insurance and reinsurance and on to the credit default swap market. Individual banks have been hit badly, especially when the special investment vehicles they set up to get the mortgage securities off their balance-sheets could not get outside financing.

Even inter-bank lending was affected. If these banks made these mistakes in mortgage lending, you wonder how badly their portfolio of auto loans, students loans and credit-card debt must be. Perhaps, we are only seeing the tip of the iceberg.

Sovereign funds to the rescue

The weakness of the overall US financial structure can be seen by looking at who has come to the rescue of these banks. These are the sovereign (government owned) wealth funds of China, Singapore, Kuwait and Abu Dhabi which have now invested money to shore-up the balance-sheets of Citigroup, Merrill Lynch, and others to compensate for losses that are collectively estimated at least 14 times what Kerviel lost for Soc Gen.

The US administration, already weakened with current account deficit reaching 6.2 per cent of GDP in 2006 has not objected to such investment.

Only a couple of years ago, when a Dubai government-owned company tried to take over the operations of six US ports, the hue and cry in the country about a West Asia government-owned company operating US ports made the company withdraw.

The US government that does not believe in interfering in the private sector any more than necessary has now put itself in a position where its most powerful financial institutions are subject to influence, even if indirect, of other governments. This is probably payback time since the US has seen its private institutions also as an instrument of its foreign policy.

For example, under US sanctions, US banks cannot be involved in trading activities with Iran. Since most other banks in the world often partner with US banks to open letters of credit, etc. this has very effectively curtailed the ability of the Iranians to trade with the rest of the world.

Call for regulation

London had earned an enviable reputation in recent years as the financial centre of the world. New Yorkers were envious at how London had managed to attract many more institutions and corporations to do deals such as initiating large IPOs than they could.

Their complaint was that the US was over-regulated, driving clients to London. But the UK is itself reeling from the crisis it faced with the failure of a mortgage bank, Northern Rock, which has led to calls for more regulation. The House of Commons’ Treasury Committee has stated in a report that the UK’s Financial Services Authority has systematically failed to regulate Northern Rock.

What is clear is that the global financial structure needs oversight. Banks and governments are too closely linked to a system that nobody is keeping an eye on. Just as individual rogue traders can upset a bank, a sleeping government can cause problems for the rest of the world.

George Soros, the hedge fund wizard from Hungary who benefits from lose controls but always calls for more regulation of the market, has called for a global sheriff for the financial sector. He should know.

The next financial arena that is likely to slip and take along with it a few billions around the world is probably going to be hedge funds, an under-regulated segment of the industry.

(The author is a professor of international business and strategic management at Suffolk University, Boston, US. He can be reached at cgopinat@suffolk.edu)

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