D N GHOSH

What was it that sparked off the subprime crisis? The massive growth of financial markets combined with a plethora of exotic credit instruments has brought about a fundamental structural change in the way the credit market operates. Traditional credit instruments such as stocks, bonds and money market obligations have been joined by a long and diverse roster of exotic credit instruments that convert non-marketable assets into marketable ones. This has been a remarkably innovative development. These innovative securitised instruments have undoubtedly some virtues: they distribute risks and impart depth, richness and price discovery to the market – all good things that the financial system can boast of. However, these instruments, the collateralised debt and loan obligations, are highly complex and opaque. One can find in the same pool highly rated paper along with low rated bonds, which makes it difficult to value and sell these instruments in times of market volatility and to know precisely where the risk lurks. Liquidity vanishes at the slightest stress. The risks of sub-prime lending were carefully concealed in the mortgage securitisation market, and with the “radioactive dust” being scattered by the winds all over the globe, none, not even the central banks, know where the specific risks are getting concentrated and where these are ending up. The way this market operates has been captured with telling sarcasm by the columnist Martin Wolf: “Sucker number one is persuaded to borrow too much; sucker number two is sold the debt created by lending to sucker number one; sucker number three is the taxpayer who rescues the players who became rich from lending to sucker number one and selling to sucker number two” (Financial Times, August 28, 2007).

We pick up clues as news filters out from the US and French hedge funds, from a reputed mortgage lender in the UK and from obscure German banks. With this opacity that lies at the root of the current financial crisis, confidence and liquidity vanish at the first sign of distress. The central banks, willy-nilly, have been driven to rush to offer a generalised remedy to avert a breakdown of the financial system. They cannot afford to wait till they track down the culprits; the need for urgency in calming the market becomes an overriding compulsion.

Over the past decade and a half, the global market has witnessed several crises: the Russian default in 1998, the implosion of the US hedge fund, Long Term Capital Management, the new economy boom and bust, and so on. Market behaviour and regulatory response have been different in detail but similar in essence – a pattern of rising prices of assets, expanding credit speculation, then falling prices, default and finally panic. Subsequently, the standard medicine: injection of liquidity so that the functioning of the market is not disrupted; a game of accusation, followed by the drama of post-mortem examination.

Concerns

As expected, the volley of accusations has generated enough heat, but where is the light? Why is it that the commercial banks as originators of loans did not do their basic homework of evaluating their borrowers? Perhaps they were not interested in doing so, for the market, with the new innovative structured products, has given them enough manoeuvrability to pass on the assets through securitised instruments assets to other market intermediaries and get relief from capital requirements that become obligatory from holding risky assets on their books. These

Economic and Political Weekly October 13, 2007

intermediaries, operating on a highly leveraged basis, market these instruments all over among global investors; ironically, their main support happens to be the commercial banks themselves. Where do the investors get the assurance from? From the rating agencies: their opinions on the underlying risks of the securitised instruments have emerged as the crucial pivot on which this market functions; the complexity of the instruments makes it impossible for the investors to come to an independent judgment on their own.

The rating agencies are now facing the flak, the fine print of their disclaimer notwithstanding. Investors have started asking whether the opinions of the rating agencies can be considered reliable, for their opinions do not take cognisance of the sensitivity of the valuations of the underlying assets to the volatility of the market. Is then their methodology of evaluating risk right? Can investors rely on the methodology in the future? Added to this is the accusation of bias arising from conflict of interest. A large chunk of the profits, about 40 per cent or so in the case of the leading international agencies, comes from fees from issuers, the originators of the securitised instruments that get rated by the agencies. Recall the ethical issues of conflict of interest that broke up the top accounting firms of the world after the Enron debacle. The regulators are all in a disarray. The nagging question is being voiced over and over again: If efficiency as well as stability of the financial system is a public good, can we leave it to the market to deliver it to us?

The present crisis has again underlined the fact that the supervisory and regulatory structure and principles are getting increasingly out of alignment with the dynamics of the global financial market. We need to flag a few disturbing trends. When risks are being distributed among different financial institutions, can we continue to live with a situation of split regulation? The overlapping of jurisdiction among different regulatory agencies is continuing to haunt us. In the US, the Fed chairman has openly spoken about overlapping jurisdiction among the different regulatory institutions. In the UK, the workability of the “tripartite system” under which the Financial Services Authority supervises individual banks, the Bank of England deals with system crises, and the Treasury acts as the co-ordinating authority is now being questioned. Can we continue to live with overlapping regulatory jurisdictions? To give an oft quoted example, we take enormous care in devising a risk weighted capital structure for commercial banks, but shy away from enforcing any discipline on the hedge funds who operate on a highly leveraged basis. The Basel norms address the limited problems inherent in any individual bank, but do not deal with (and nor is it their task to do so) the wider issue of rationalising the different and widely varying market norms of many other financial institutions, which can be crucial for ensuring stability in the market.

One needs also to ask whether regulatory supervision is losing its bite. Take the episode of Northern Rock, the mortgage lender that continued to fund longterm assets with short-term money market instruments and commercial paper. Why is it that the regulators were keeping silent? Why did they allow Northern Rock to continue to operate on a business model based on wholesale borrowing to fund long-term retail lending? Did the regulator concerned tell Northern Rock (which boasted of being Britain’s fastest growing mortgage lender) that the terrible mismatch between its assets and liabilities would blow it off at the slightest contraction in the credit market? Again, consider the rapid change in the structure and organisation of the market. The growing dominance of big financial conglomerates is an extremely disturbing issue. Can we expect the different agencies supervising parts of such conglomerates to have a grasp of the developments in the conglomerate as a whole? In the current scenario, given the fact that the risk bearing capability of small institutions is very limited, the inevitable tendency is to create large institutions through mergers and acquisitions, thereby eroding still further the regulatory efficiency of the central banks. Again, come to the role of the rating agencies. If the regulators are responsible for market soundness and stability, they have to seriously rethink whether it is wise on their part to leave the present system of evaluation of risks to the market, that is to the private rating agencies, when, in a crisis, they can get away quoting the disclaimers, leaving the central banks with no option but to bear the consequences and hold the baby. Shall we continue to live with a situation in which regulators have no say in the regulation and supervision of the rating agencies?

Outlook

We can no longer avoid these issues. The rationale behind opting for a market economy is that it will punish the culprits; those who have been irresponsible and have indulged in recklessness will be weeded out. Clearly, we have been seeing that markets are unable to control their own players, who have been consistently creating situations in which regulators have had to come out as saviours. Markets think they will continue to thrive “under the best of all possible worlds”, despite the sanctimonious outpourings of central banks paying lip service to the principle of moral hazard. The market knows that when the crunch comes, their sacred principle will give way to “enlightened pragmatism”. When the market was feeling the first signs of distress, it was unanimously pressing for a “flexible approach”, and was jubilant when the regulators announced an “unconditional surrender”. This is what is happening in all the key markets and this will continue to be so in the future unless the regulators wake up. We have to face the question squarely. Can we rely on the market to enforce self-discipline, when we have, in one crisis after another, found that it suffers from a congenital lack of such selfdiscipline? Experience seems to have no meaning for those who operate in the financial market; the market participants do not learn, international bankers do not learn, and sadly, even regulators also do not learn. The time has come when central bankers must show their character and mettle; if they want that the global financial system does not, through such recurrent crises, lose its credibility, they must show that they deserve respect and win credibility. They have to assert themselves and devise a different pattern of regulatory structure and principles in the changed context; they should not shy away from interventionist regulation when it has been clearly demonstrated that the market has consistently failed to punish the guilty. Or are they powerless in an ambience of globalised finance and they are telling us to live with the inherent fragility of a global market? Is it in the interest of the political governments to continue to be a party to a structure of regulation that does not know how the risks are developing and getting distri buted all over the globe? Should they not move for the creation of an institutional mechanism on a global scale so as to pre-empt any threat to the system? That perhaps is a distant dream. While the debate goes on ad infinitum, let the market enjoy itself

– it has had its biggest prize; it has captured the regulator!

EPW

Email: dnghosh1@dataone.in

Economic and Political Weekly October 13, 2007