How much regulation is optimum regulation? This is a question that has been assailing the minds of economic stalwarts. The sub-prime crisis has brought to the fore the age-old debate between market and state regulation. Should the sub-prime crisis be seen as a case of complete market failure or failure of regulatory oversight? Or are both responsible?

Theoretically, markets relying on the incentive structure provided by a system of pure private property rights, zero transaction costs and complete information are the most low-cost institutions to harness individual self interest.

However, the smooth functioning of markets is hindered when in reality, they are faced with non-zero transaction costs, ill-defined property rights and imperfect information. It is argued that government intervention in such cases may lead to efficient outcomes. But, even in the worst of these cases, advocates of free market theory do not recommend complete supplantation of markets.

In this background, one needs to examine whether the sub-prime crisis represents a case of permanent market failure or a temporary disequilibrium which requires short-lived state assistance to tide over the ex-post frictional cost of adjustment to equilibrium? If it is the latter, then it calls for a more serious co-ordination between state and the market, rather than pre-dominance of either.

The reasons for the sub-prime mortgage market failure of August 2007 seem to be in-built in the structure of the sub-prime mortgage market and market innovations. By mid-2006, the mortgage market in the US was equally shared between Government Sponsored Enterprises (GSEs) such as Fannie Mae and Freddie Mac and other non-government mortgage originators, including some thinly capitalised, unregulated finance companies.

The sovereign security that GSEs handed over to prime mortgage buyers exuded an implicit confidence in private markets that the mortgage markets are too big to fail. Such a confidence spill-over, coupled with demand for high-yielding risky assets from unregulated non-banking institutions such as hedge funds, led the markets to subvert their traditional rules and open the windows of credit to non-credit worthy, high-risk prone but at the same time high-yielding sub-prime mortgages.

Under a sovereign security and low interest rate environment, markets encounter the problem of adverse selection as people who are not so serious about returning loans also participate. Secondly, outsourcing of broking functions to mortgage brokers further adds to the principal-agent problem for banks. Brokers have less incentive to adhere to loan documentation standards, resulting in an explosion of unsustainable sub-prime loans.

Financial practices such as securitisation further emboldened this market confidence by promising that any amount of risk could be absorbed by the system. It encouraged mortgage originators to assume risks disproportionate to their risk-taking capabilities, as neither the credit risk, nor liquidity risk, nor market risk appeared in their balance sheets.

In this process, concerns about the quality of the loans were put on the backburner. Securitisation gave birth to two related problems. One, though the default losses were reported as early as 2007, no precise estimate about sub-prime assets, quality of underlying assets and geographical spread of these instruments are available till date. This, in fact, bred suspicion and led bankers to withdraw funding from originators.

Two, since sub-prime mortgage securities were bundled with prime securities to enhance their marketability, risk from the sub-prime mortgages had a contagion effect on other healthy assets. This led investors to reassess even the investment grade risk segments. Further, banks and broker dealers who had underwritten the structured investment vehicles and issued the commercial paper had to honour them. In other words, those assets which banks wanted to move away from their balance-sheets had to be reinstated into their books, thereby imposing an additional burden of capital requirements on banks and damaging their reputation.

Moreover, there was a wedge of information between sellers (mortgage brokers), who had complete information about the securities, and buyers who relied blindly on prices disclosed by the credit-rating agencies.

The latter, in turn, failed to price the risks properly because the use of originator and distribution models blurred the information about the quality of asset underlying the derivative instruments.

Similarly, the use of complex and non-transparent financial products such as collateralised debt obligations (CDOs) further aggravated the information asymmetries.

The complexity and lack of knowledge about the reaction functions of such products during the crisis led hedge funds and institutional investors to withdraw liquidity from such markets.

In a nutshell, the sub-prime mortgage market was throughout saddled with information asymmetries and negative externalities — the primary enabling criteria for state interference — which made the market unsustainable from within.

But the moot question one is confronted with today is: Should this be treated as a permanent market failure with the only remedy being increased state regulation? In reality, there is nothing called permanent market failure. By nature, markets are self-equilibrating. In case of the sub-prime crisis, as demand for housing rejuvenates and housing prices rise, equilibrium would automatically be restored in the sub-prime mortgage market.

However, the journey to equilibrium would be protracted and painful, characterised by dismantling of old institutions (banks and hedge funds) and creation of new ones — what Joseph Schumpeter calls the process of creative destruction. But the journey to stability can be eased and shortened through state assistance, which has actually taken place.

Hence, injection of liquidity by central banks and bailing out of certain banks and non-banks should not be construed as breaking down of market system and usurpation of financial system by the state. It is an attempt, a short-term measure by the state to restore long-term investor confidence in the financial system that a financial crisis generally erodes.

In fact, given the increasing share of the financial sector in domestic GDP and the rising integration between financial markets worldwide, restoration of financial stability has itself become a core fiduciary sector activity, just like maintenance of law and order and public infrastructure.

Ultimately, the question is not about a trade-off between the state and the market but about a delicate co-ordination between the two institutions to enable smooth functioning of the financial market system. In that case, should financial crises like this be used as a pretext to curb Adam Smith’s invisible hand?

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