The Hindu Business Line : Convulsive crisis of capitalism

The present global financial turmoil, characterised by a weak economic environment, low liquidity and volatile debt was triggered by the sub-prime mortgage crisis in the US. The International Monetary Fund’s twice-yearly Global Financial Stability Report warned that many of the lax lending practices of the past few years will have to change and economic growth will be crimped by the current correction.

This observation seems to acquire poignancy in the wake of the breakdown in the world capitalist system — widely acknowledged to be the worst crisis since the 1929 stock market crash. The bailout of Bear Sterns by the Federal Reserve, the takeover of Fannie Mae and Freddie Mac (with the US treasury extending $5.3-trillion government guarantee to private debt, nearly five times India’s GDP), Lehman Brothers filing a Chapter 11 petition with the US Bankruptcy Court in Manhattan, takeover of Merrill Lynch by Bank of America and emergency funding of AIG by the Federal Reserve are symptomatic of a larger malaise: a devastating crisis of confidence. It cannot possibly get any worse, can it?

The real fault-lines

The real and worrisome fault-lines in the working of such exalted institutions as the Federal Reserve, the Securities and Exchange Commission (SEC), the dubious process by which ratings are arrived at and the fallacies of the “too-big-to-fail” hypothesis transformed standard management practices and rendered conventional models of strategy and growth obsolete.

At best, these revered institutions overlooked the excessive leveraging of equity to the extent of 30-40 times by investment banks such as Bear Stearns, Lehman Brothers (founded 158 years ago) and others; at worst, these institutions colluded in the elaborate and meticulously worked out farce.

It does not need rocket science to know the catastrophic impact of even 5 per cent erosion in value of $600 billion worth of assets on an equity base of just $26 billion, i.e., a factor of well over 23. Lehman’s position was not a flash in the pan because both Fannie Mae and Freddie Mac just had a capital adequacy ratio of around 0.5 per cent, which made it impossible for them to bear the mounting losses in the wake of huge mortgage defaults and the US house-price collapse.

In hindsight, it is clear that not only was the whole investment-banking model saddled with inherent contradictions but there were also serious deficiencies in risk measurement and management of the entire system of complex financial instruments.

The worsening sub-prime crisis could conceivably cause a liquidity crunch, aggravating the slowdown and precipitating a recession. All this also occurred because of the regulatory forbearance that has characterised the ostensibly “transparent” but actually opaque markets that are typical of modern finance.

Indian banks’ exposures

India is not exposed to the new and innovative financial instruments that brought about this financial tsunami, there are large foreign exchange reserves making it possible to tide over any short-term disruption in capital inflows.

Six public sector banks (PSBs) and ICICI Bank have a total exposure in Lehman Brothers of approximately Rs 640 crore, with ICICI’s exposure alone being nearly Rs 400 crore. But ICICI’s exposure is quite modest in relation to its huge investment assets. Hence, the exposure is clearly limited.

Indian PSBs are well regulated and have strong balance sheets. Thus, while the banking system is immune from the present global imbroglio and there is no systemic concern, negative global sentiments will adversely affect liquidity and the outlook of the banking as well as other sectors of our economy.

Indian banks and financial institutions can no longer afford to exist in cocoon or adopt an ostrich-like attitude in the wake of the inexorable process of globalisation. And the dangers of progressive across-the-board liberalisation make it necessary not to be oblivious of safeguards while moving ahead with financial reforms and bringing in best practices in mapping the future of Indian banking.

(The authors are Chief Economist, Canara Bank, Bangalore and School of Management, IIT Kharagpur respectively. blfeedback@thehindu.co.in)

Related Stories:
Lehman Brothers files for bankruptcy
S & P downgrades top US investment banks
Of Bears and broken markets

More Stories on : Financial Markets | Insight

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Claustrophobia in the air

Negotiating FTAs

Ranbaxy’s Achilles heel

Convulsive crisis of capitalism

Contrasting styles of expression

Futures prices in US