The Hindu Business Line : Regulate… in right measure

As long as markets exist, there will be risks of market failure. And we need a public regulator to prevent the risks from exploding into a crisis, says RUDRA SENSARMA.

The present crisis in the global financial system is being compared to some of the biggest in history such as the Great Depression of the 1930s. Each new day brings news of another financial institution failing or getting bailed out by the government. Are greedy bankers to blame for this crisis; is too much complexity in the financial world the real problem; or is it the government-run regulatory systems that have failed? While the Indian financial sector may have remained relatively unaffected so far, there are immediate lessons to be learnt and action plans to be implemented.

Some commentators have blamed weak regulation for the crisis, saying the regulators failed to prevent banks from lending to sub-prime markets. Regulators should have cautioned financial institutions against investing in mortgage-backed securities. They should have controlled the explosive growth in derivatives markets and not allowed insurance companies to insure bad assets of the banking industry.

Other experts have blamed the very existence of regulation for the current mess, stating that free markets do not need government interference. Without regulation, the markets would have functioned by themselves and bad elements would have automatically collapsed, leaving the good ones to function in a healthy financial system. When the government provides guarantees and protection to the bad elements, it provides incentives to the good to turn bad — what is technically referred to as moral hazard. Hence, the government should stay out of the game.

Tightrope walk

Unfortunately, it is not that easy in the financial system. This is a sector where customers (depositors, borrowers, investors or clients) have incomplete knowledge of the product they buy and, often, the producers have incomplete knowledge of the products they sell!

It is important for a public regulator to stand by and watch, to ensure protection of customer rights (as caveat emptor is not enough) and to prevent excessive risk taking, malpractices and fraud. Financial institutions are intricately linked to each other through a complex web, and one brick falling out can bring the whole house down. A government authority is necessary to prevent even one domino from falling. As a result, the regulator has to walk a tightrope between too little regulation (as public regulation of private markets is necessary) and too much regulation (as that creates moral hazard).

So, where did the regulator go wrong this time? It emerges that the regulators did not take cognisance of the fact that the financial system had undergone a paradigm shift in the past decade and it is not the banks alone that matter. The broker-dealers or investment banks have become the bigger players but the regulators forgot to keep adequate watch on them.

The justifications for commercial bank regulation are in principle similar to those for investment bank regulation. The fear of a run on a commercial bank by its depositors is now joined by a fear of a run on an investment bank by its creditors. But the regulators failed to impose appropriate capital adequacy norms, risk management guidelines and transparency norms on investment banks. As a result, these institutions were out on the loose. To compound the problem, regulators have little understanding of off balance-sheet activities such as derivatives. In the confusion over who holds the ultimate risk of a derivative product that has been, what I call, ‘multi-engineered’ (that is, engineered multiple times) and whether a credit default swap (such as those offered by AIG) is an insurance or a derivative product, the system fell apart.

How to regulate

Taking cues from the international group known as the Basle committee, regulators have been harping on management norms for credit risk and market risk. But at the heart of prudent regulation lies the ability to distinguish illiquidity from insolvency. Unfortunately, regulators ignore the difference and do not lay sufficient emphasis on liquidity risk management. Today, it is clear that maturity mismatches between assets and liabilities are the biggest foibles of financial institutions.

Therefore, regulators must lay greater emphasis on liquidity risk management and there is need for uniform norms in this age of international banking (as in the case of Basle capital adequacy norms). Second, investment banks must be regulated at par withcommercial banks.

Strict capital adequacy regulations will keep a check on excessive leveraging, which is commonly seen as the core reason for the current crisis. Both ‘on balance-sheet’ as well as ‘off balance-sheet’ assets must be backed by adequate capital so that shareholders sufficiently participate in the risks that the firm is exposed to.

At the same time, investment banks certainly need some amount of liability insurance (from credible organisations such as the FDIC in the US) to prevent bank-like runs. They require a formal ‘lender of last resort’ window from the central banks and that window must remain open credibly and in unlimited amounts (unlike the ad-hoc way in which it is being used by the Federal Reserve Bank).

The point is that if the central bank commits to lending unlimited amounts to a financial institution, then the need to lend will not arise at all! At the same time, there has to be a gradual move towards universal banking where the exposures are diversified and the risks are lower. The current crisis has exposed the weaknesses of the business models followed by investment banks.

Role of shareholders

A common grievance has been that CEOs of investment banks, egged on by aggressive traders, ignored the concerns of their risk management teams and greedily took on greater risks. To prevent this, shareholders must take greater responsibility in determining the business models and, consequently, the long-run risk-return tradeoffs acceptable to them.

Apart from relying on improved corporate governance, an improved system of regulation should force owners and managers of financial institutions to control excessive risk-taking even through off balance-sheet activities. CEO compensation schemes surely need a re-look (several European countries are already implementing suitable legislations to control skewed incentives).

While, once again, the shareholders can be the main drivers for this change (for example, the ‘say on pay’ systems in the UK and Australia), the regulator must think of ways to address managerial incentive schemes that drive aggression. This would not be very different from the principle that leads regulators to stop firms from abusing market power.

Lessons for India

The RBI may be tempted to pat itself on its back for going slow in promoting the use of derivatives — the Frankenstein’s monster that has come back to haunt its creator. However, derivatives find use as tools of risk management and not risk taking. They offer huge benefits to the financial system. Regulation of financial institutions should encompass greater understanding of the risks that reckless use of derivatives pose, rather than throwing out the proverbial baby with the bath water. We must introspect whether we need complex ‘over the counter’ derivatives or whether we can live with simpler ‘exchange traded’ derivatives that are more transparent and carry less risk. Similarly, we must determine the degree of engineering permissible on an underlying asset and how such multi-engineered products can be rated objectively.

Related to this is the issue of regulating off balance-sheet activities that allow banks to hide their risks. For example, an insurance company selling a credit derivative should be regulated by the rules governing that activity and not by rules governing insurance activity alone. Bigger and healthier banks must be encouraged by allowing consolidation and promoting universal banking for diversification of risks. Regulation must emphasise capital adequacy for on balance-sheet as well as off balance-sheet activity, enforce liquidity risk management norms and monitor executive compensation schemes. Finally, the regulator can hire professionals with the training and market experience to handle the complexities of the financial sector. They can even be offered higher pay and perks for short-term consultations or longer-term appointments.

The Western world pioneered the current systems of regulation that now seem be falling apart. The mighty US government is struggling to make amends even as the Treasury Secretary advises other countries to follow the American example in dealing with the crisis!

The bottomline is that as long as markets exist, there will be risks of failure. And we need a public regulator to prevent the risks from exploding into a crisis. The current regulatory structures have been found inadequate on several fronts. There is no harm in admitting that regulation is as much a dynamic process as market practices are and, hence, needs to evolve with every crisis. We need the regulators to be around, but we need them to rethink and reinvent regulation.

(The author is senior lecturer in Finance, University of Hertfordshire Business School, UK. blfeedback@thehindu.co.in)

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