The Hindu Business Line : 3-6-3 to NINJA banking

So much has already been said about the sub-prime crisis. But what caused it is still a matter of conjecture and suspicion… just like Benazir Bhutto’s death.

Was it the low interest regime and then subsequent tightening? Was it lax supervision or mispricing of risk? Were there promiscuous underwriting standards or adverse selection? Or was it just plain greed and deceit? Was the falling housing market the final nail in the coffin or was it the commercial compulsions of the rating agencies?

The version depends on who you are – central banker, financial innovator, investment banker, risk officer, investor in CDO/MBS, etc. etc.

Basel challenge

Be that as it may. Creating maximum credit per unit of capital has been a challenge since the Basel regime came in. Securitisation has proved a handy tool to beat the rigours of this regime. But layers of securitisation have created their own leverage; so have shifting of on- balance sheet items to off-balance sheet. Derivatives blended with securitisation were used to aggregate, then reaggregate, then disaggregate and finally redistribute risk outside the Basel family. After all, you need to keep the family safe!

There were many cops to keep the Basel family safe. But they didn’t. Like the typical cops they rounded up suspects and let the guilty free. Probably our very own RBI’s monetary policy documents in recent times, particularly those referring to mispricing of risk and dangers of mortgage lending, were not on the recommended Basel reading list!

High level of consumption as a sign of sophistication of the system is a cultural belief in many societies; but when monetarists start embracing this belief, the consequences for the financial system could be dangerous.

This cultural belief, which finds a prominent place in the business lexicon of such societies and is fed by retail banks, has had its share in the creation of the sub-prime crisis.

Back then, bankers were rewarded for resource mobilisation, and more so for success in getting retail deposits. Those salad days have gone. Bank managers have turned financial engineers and world of banking is never the same again!

Leaky pillars

All three ‘pillars’ of the Basel family look leaky. Credit risk models/ rating agencies failed to capture the true intensity of risk; in some cases, these models were approved just a few days before the breakout of the crisis. As usual, the supervisory regime fell behind the racing innovation (incidentally, innovations do have a tendency to get stifled under too much scrutiny). Disclosure standards acted like the proverbial miniskirt, revealing less than what they were concealing; it is so hard to get correct information, let alone the truth. After all, what do you say of a bank boss who famously said that customers flocked to his bank even in such trying times and a few weeks later announces huge losses and, infamously, quits - Information Asymmetry? It may be better to revisit Basel 2.

Regulators/ supervisors are clue-less and tool-less to carry out the necessary plumbing. Clue-less as to whether this is a liquidity or a solvency crisis – it is not chalk or cheese yet. Earlier pretensions that there is only liquidity crisis are proving false going by not just the money market operations of infusing liquidity but also credit operations where central bankers, like the ECB, are taking on credit risk – almost unheard of earlier.

Moral hazard

The huge bail-out of Northern Rock with over $100 billion involved in cash and guarantees – what a moral hazard! There appears to be some confusion on the primacy of lender of last resort and deposit insurance function. Before one could begin to hazard a guess on the dimensions of the crisis, the ECB surprised markets with a munificent $500 billion package.

While delivering a vote of thanks at a function, Mr Rakesh Mohan, Deputy Governor, RBI, offered technical expertise to the ECB Governor, tongue firmly in cheek. However, looking at the depth of the crisis, the offer may not entirely be uncalled for.

In banking, we used to have comfort of the “lender” of last resort, while the non-financial sector had “buyers” of the last resort. Now, we have buyers as the last resort in financial sector too, with the Chinese and Saudis rescuing the likes of Morgan Stanley and Citi.

Why not the Ambanis and the Mittals entering the global financial arena? Could be a good beginning for sovereign wealth funds. Then the whole consolidation game in the Indian financial sector can leapfrog. We have seen the ascent of Indians on the global scene – the time has come for the ascent of India.

(3-6-3: The ‘unofficial’ banking rule - take deposits at 3%, lend at 6%, go play golf by 3 O’ clock; NINJA : No Income No Job Assets)

(The author is the Chairman and Managing Director of Corporation Bank. The views expressed are personal.)