The Hindu Business Line : It’s back to basics now

In an ethos more fascinated by format than by content, this infamous term (sub-prime lending) spurred competition among financial institutions that took unsafe and unprincipled lending to unprecedented levels, says R. SWAMINATHAN.

Time was when the financial sector, principally the banks, was conservative and circumspect. They took good care of their clients’ funds and were very strict in observing their lending norms. Loan applications were scrutinised with extraordinary care and were summarily rejected in case of the slightest doubt.

The interests of the depositors were paramount. Ironically, words such as “transparency” and “due diligence” had not been invented then. As if to physically represent the soundness of their institutions, banks had their corporate headquarters in massive, solid buildings. True, there was no frenetic growth in either deposits or lending. But life was predictable, safe and secure.

Jargon crunching

By the 1980s all this changed. Financial institutions in the US started adopting aggressive practices to enlarge their businesses. “Innovation” and “new products” became the buzzwords. Instead of collecting their outstanding loan over the stipulated term, such outstanding debt was “securitised” and sold away.

Jargon crunching kept abreast of such developments. Terms such as “lending to hold” and “lending to distribute” were freely bandied about. With the dog-eat-dog US corporate culture permeating financial institutions, competition among financial institutions spawned more and more esoteric products.

“Derivatives”, “junk bonds”, “futures” et al proliferated at an alarming pace. When greed became the driving force, zeal replaced professionalism. Being one up on competition became the only goal. Unsurprisingly, herd mentality took hold of financial institutions. And equally unsurprisingly, financial crises were precipitated with monotonous regularity.

Theorising practices

From Indonesia’s Pertamina crisis of the mid-1970s (the billion-dollar bubble), through the Mexican crisis of the mid-1980s to the BAM crisis and the 1997 East/South-East Asian currency meltdown, recent history is dotted with stories of failed economies policies, stymied by indiscriminate banking and financial sector practices. Strangely, this was also the period when the same financial institutions of the US were lecturing the rest of the world on “best practices”, “moral hazard”, “due diligence”, “stakeholder interests” and “transparency”.

Auditing firms and rating agencies also multiplied and acquired an awesome stature. Artificial pearls of wisdom scattered by these institutions were lapped up by an overeager audience, which sadly believed that their interests were safe with such institutions totally committed to their clients’ welfare. The truth, however, was bitterly different. These institutions never bothered to translate their rhetoric into practice.

Sub-prime lending

In this milieu, jargon crunchers started working overtime. The most enchanting product of such wordsmithy was “sub-prime” lending. In plain English it meant giving loan to a non-creditworthy client.

In an ethos more fascinated by format than by content, this infamous word spurred competition among the financial institutions and took unsafe and unprincipled lending to unprecedented levels. And these disastrous loans were also transmuted by jargon into more esoteric products and sold to institutions and gullible individual investors.

Derivatives, futures, etc., multiplied at an alarming rate and now we read reports that some of the futures transactions had no physical assets underpinning them. The financial institutions thus spread the virus of their indiscretion far and wide.

It would be amusing but for the tragic consequences — to hear treasury officers of firms and even some banking professionals confessing, post facto, that they did not understand the financial product(s) they were persuaded to buy. Mesmerised by esoteric terminology, these finance professionals with impressive academic credentials, proved to be more gullible than imagined. But the consequences of their naiveté have dealt body blows to economies around the world.

Partners in crime

There are two other actors in the arena, who are no less culpable for the financial meltdown. Auditing firms are mandated to scrutinise the accounts of their client corporates and point out irregularities and get them reversed before certifying the accounts as correct.

That is the reason that “audited accounts” are relied upon for as reflecting the true state of affairs on ground. The bigger auditing firms — termed as Big Four or Big Five — pontificated to the whole world about IAS (International Accounting Standards), transparency and what not. But, in practice, many of them developed a cosy relationship with the giant corporates and became willing partners in their shenanigans. They turned a Nelson’s eye to the accounting sleights of hand practised by their clients and thus kept the truth away from the general public. Credit rating agencies were created to professionally rate firms and put that information in the public domain for the benefit of the market. But, over time, these CRAs also started playing games. When the going was apparently good, they were generous with their ratings. And at the slightest hint of trouble — particularly after the 1997 East/South-East Asian economies caught them with their pants down — they indulged in what one could call “anticipatory downgrading”.

Both ways, they muddied the waters and worsened the crises. By exercising their power without any sense of responsibility, the CRAs failed to live up to their original mandate of fair and objective rating.

Failure of governance

The current implosion we are witnessing in the financial sector of the US is the cumulative result of all such questionable practices over the years. There has been a comprehensive failure of “governance” in these banking and other financial sector institutions. Not only has there been no transparency, but accountability is also significantly missing.

The golden handshakes given to the CEOs of these failed institutions reward incompetence, at best, and venality, at worst. The logic of not punishing but rewarding these top echelons is difficult to understand.

Oversight by regulatory agencies has also been poor and haphazard. And the US government, which thundered “moral hazard”, when some third-world country bailed out some failed financial institutions, has selectively bought up some institutions and now is all set to establish a public sector asset management institution, which will take over all the bad and questionable debts of the BFSI institutions and undertake a “work-out” to clean up the mess — all at the taxpayers’ expense. Clearly, principles are only for preaching, not for practice.

Lessons for the future

What has happened is tragic, more so because of its global implications. As the largest economy in the world, the financial and corporate tentacles of the US have a global reach. When the US sinks, it will take the rest of the world along with it. However, if the right lessons are drawn from this disaster, the crisis would at least have served a purpose. But that would need a paradigmatic change.

Banking and other financial sector institutions would have to go back to basics. Respect for other peoples’ money, professional integrity and morality in transactions have to be restored. So-called “product innovation”, which falls in love with itself and goes berserk, resulting in esoteric products that lack sound financial underpinning needs to be eschewed.

Mission statements and other lofty principles expressed in purple prose would have to be taken seriously and implemented faithfully. Transparency, accountability, predictability and participation should truly become the operating principles of corporate governance, instead of being shibboleths as they are now. The financial sector is the life-stream that supports and nourishes the real economy. If that flow gets poisoned at the fountainhead, how can the downstream effects be non-toxic and benign?

(The author is former Secretary, Asian Development Bank, Manila. blfeedback@thehindu.co.in)

Related Stories:
No light at the end of tunnel
‘Securitisation, a (sub)prime option’
Nightmare on Wall Street

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