Rajesh Haldipur

All financial innovations should pass through strict regulatory filters and be specifically approved. This prevails in India and is partly why, in spite of being more globally integrated than ever before, India remains stable and insulated from the recent goings-on in world markets, points out RAJESH HALDIPUR.

Spectacular financial crashes have become far too common in the last 10-12 years. The Asian currency crisis, that hit Malaysia, Thailand, Indonesia, et al, the Long-Term Capital Management collapse, Barings Bank, Enron and WorldCom, Amaranth Advisors and, most recently, Bear Stearns, are well-known to discuss.

Beyond these, there are those who got away but had their unexpectedly high risk exposures exposed. Northern Rock, Bankers Trust, Citibank, UBS, Merrill Lynch and JP Morgan are all near-misses. India has been largely left unscathed — can there be possible remedies in this experience to avoid such upheavals?

Main Culprit

Excessive leverage (too much debt compared to equity) is the common culprit in all financial market crashes – be it in 1929 (leverage by investment trusts) or 1987 and 1994 (leverage through collateralised debt and mortgage obligations and junk bonds) or 1998 (excessive leverage by LTCM and other hedge funds) or 2001 (leveraged bets on dotcoms) or 2008 (world-wide leveraged bets that US housing prices would not go down; and that interest rates won’t fall).

We laughed at South Korean chaebols that crashed under the weight of 500:1 leverages through combinations of low interest and crony-banking. From the vulnerability the banking sector has shown globally in the last two quarters, it is likely that the world’s major banks have leverage ratios in that range, if off-balance-sheet exposures to derivative instruments, investments in SIVs/SPVs, and negative exposures to yen-carry trades were to be accounted for.

Most of these innovations tend to create downside exposures to assets they do not own. And it remains hidden because off-the-books leverage through exposures to swaps and so-called Special Investment Vehicles are rarely disclosed; when disclosed, net exposures (not gross) to derivative contracts are disclosed cryptically in a note somewhere in fine print.

Gross exposures are relevant because in an endemic downturn, you can get hit on both sides – due to market price risk on one side, and counter-party risk (of the other party refusing to or being unable to honour his obligations) on the other.

While banks traditionally have higher leverage than other businesses, countries where banks either avoided, or were barred from investing in difficult-to-value derivatives, and consequently did not leverage excessively, have been left relatively unscathed. In India, only ICICI Bank has reported significant losses in the sub-prime crisis.

There is a strong case to limit total (including off-balance-sheet) leverage, because bailouts perpetuate a moral hazard. If taxpayers have to bail out commercial and investment banks (witness the US Fed’s intervention to protect Bear Stearns; and Bank of England’s bailout of Northern Rock), governments must impose tighter limits on risks banks can take. Two as yet unresolved risky leveraged exposures of global financial markets are:

Massive amounts of “carry trades” (short-term borrowings in “cheap” currencies used to make long-term investments in jurisdictions where returns are “higher”), mostly in Japanese yen; and

Mountains of debt raised by PE players.

Before the dust dies down on the sub-prime crisis, the world’s central bankers need to think of mechanisms to soften the global impact of the inevitable denouement of these exposures.

Financial innovation that insidiously creates overleveraged exposures needs to be tempered. Suggestions (such as The Economist made in a recent article) that attempts to curb financial innovation would do more harm than good need to be debunked.

All financial innovations should pass through strict regulatory filters — terms of structured notes/offerings have to fall within approved strictly defined categories, or be specifically approved.

This prevails in India, and is partly why, in spite of being more globally integrated than before in living memory, India remains stable and insulated from the recent goings-on in world markets.

India has managed political consensus in economic decision-making (in spite of the frictional forces inherent in a true democracy), maintained the strength of its currency within acceptable bounds to all interest groups, and managed inflation at home while growing at a blistering pace consistently in the last 7-8 years. Hence, it would seem that it is time for the West to take some lessons from India.

Lessons to learn from India

Lending without moral hazard: In India, most lending is like a marriage between the borrower and the banker — until death do us part. In the West, thanks to securitisation, it is a marriage of convenience, or even a one-night stand. Banks in the West can — and almost always do — reduce exposure to any single client by “passing the parcel” — because a predominant portion of debt is structured in form of tradable debt securities.

This is good for a bank, but not good for the economy — a typical “Tragedy of the Commons”. The bank that floats an issue has no incentive to see that the borrower honours obligations till maturity, because very shortly, its exposure to that client gets reduced to near-zero.

This creates a moral hazard — “sub-prime” borrowers find it easy to raise money because of banks’ appetite for debt securities. With rating agencies being dependent on more issues, there is an in-built moral hazard there too, that exerts an upward pressure on ratings. This is why no bank now believes that AAA+ rated debt is really that.

Maternal Wisdom: To teach fairness, our mothers asked one child to cut the apple, and the other sibling to choose the piece. This effectively eliminated fights about who got the bigger piece.

Applying this principle to derivative offerings, one can force issuing bankers to not transfer till maturity the riskiest part of any securitised bond offering — called “nuclear waste” by Wall Street veterans. This could enforce honesty about riskiness of the offer, and circumspection in their structuring.

Avoid Turf Wars: In India, as in the UK, there have been no serious regulatory turf wars. Regulation in the US has been ineffective partly because structured notes and tradable debt securities with complex covenants often fall between the turfs of the CFTC and the SEC.

Buy Gold: Indians have bought gold for decades when the whole world was selling it. Privately owned gold inventory in India is largest in the world.

With gold touching record highs, the increase in its value has had a security-net impact. For decades, we saw gold as a poor investment, but thanks largely to our womenfolk and religious beliefs, Indians have ignored this and invested in gold. This is now paying off.

Live within your means: Indians have internalised the benefits of thrift; the average US citizen has never postponed gratification, and is now learning the ills of profligacy. Americans are being hit by several forces at once: fall in house prices, rising unwillingness of banks to extending “sub-prime” loans, their own free-spending habits, rise in oil and food prices, and increasing flight of jobs overseas.

Many American home owners are highly leveraged – even small rises in EMIs force them to default. They also fear bankruptcy less, because they can begin life anew. In India, a debt once incurred cannot be ducked.

Have less interlinked systems: Banks in the West have predominance of tradable securities that are heavily traded on their asset side. Asian banks have more non-transferable loans, which makes them “loosely coupled”. Western financial markets are “tightly coupled”; that is, systems are inextricably intertwined with no “play” to adjust exposures, and work very well when everything behaves predictably.

Unpredictable behaviour creates the financial equivalent of highway pileups. In India, these hardly used to happen because Indian drivers and bankers alike are more alert to the unexpected. Automated stop-loss limits and programme trading, inter alia, cause markets to slide incredibly fast. Indian stock markets are seeing that regularly nowadays – FIIs are carriers of this infection.

There is wisdom in this: tightly coupled, “efficient” markets are not necessarily good for long-term survival. India being more informally, and therefore, less tightly coupled, it gets more small hits but is capable of avoiding bigger crashes.

Finally, one prescription for India.

Reject Fair Value Accounting

Fair value accounting (as against historical cost) causes volatility in income statements in a vain attempt to make the balance sheet look fair. An oversimplified example: a small restaurateur owns a shop (the major asset on its balance-sheet), and earns its income from, say, selling dosas.

The gyration in the shop’s fair value from quarter to quarter will cause dizzying percentage jumps and drops in reported earnings of his business, which makes no sense because the shop is where it is, it still houses the business that sells crisp, fresh dosas, and there is no real change.

Fair value accounting should be relaxed to exempt companies from marking-to-market those assets it intends holding indefinitely.

This will incentivise them to insulate their income statements from volatility, making reported earnings more predictable. It may be good for the Institute of Chartered Accountants of India to re-assess the concept of fair value accounting.

(The author, a chartered accountant, is Dean and Professor, Finance, at the SDM Institute of Management Development, Mysore. These are his personal views.)

Related Stories:
Prime cause of sub-prime crisis
Sub-prime: An American loan mela at global cost
Why sub-prime is not a crisis in India

(This article was published in the Business Line print edition dated June 25, 2008)
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