Lessons for Mr Subbarao from the International Credit Crisis

HT PAREKH FINANCE COLUMN

model is old-fashioned, and, to be fair, many banks were not any good at it. But instead of removing banking licences from bad banks, regulators in Basle decided to do away with relationship- banking altogether and promoted a switch away from bank finance to “market finance”. In market finance loans are securitised, given public ratings, sold to many investors including other banks, and assessed using approved risk tools that are sensitive to publicly available prices. Now, bankers lend to borrowers that everyone else is lending to, the outcome of a process where the public price of risk is compared with its historic average and prudential control is applied based on public ratings.

Market Finance

This switch to market finance improved the appearance of liquidity in quiet times. Credit risk that was previously bundled with market and liquidity risk was separated, priced and traded. This improved the transparency and tradability of risks in the good times, but it came at the expense of systemic liquidity when markets were under stress.

Almost every economic model will tell you that if all the players have the same tastes (reduce regulatory capital) and have the same information (public ratings, approved risk-models using market prices), then the system will sooner or later send the herd off the cliff edge [Persaud 2000]. And no degree of greater sophistication in the modelling of the price of risk will get around this fact. In this world, where falling prices generate more sell-orders from price-sensitive risk models, markets will not be self-stabilising but destabilising and the only way to short-circuit the systemic collapse is for a non-market actor, like the RBI, to come in and buy up assets to put a floor under their prices. This is what the US Federal Reserve, the European Central Bank and the Bank of England have been up to.

This is a legitimate model: the marketisation of finance and the resulting improvement in liquidity in quiet times, coupled with direct state intervention in the crisis. It is the model we have today in countries under the Basle Consensus of banking regulation. But I venture that it is a

Economic & Political Weekly

highly dangerous model. It is expropriation of gains by bankers and socialisation of costs by taxpayers. Paying for a decade of bank bonuses can be very expensive for the taxpayer and the opportunities for moral hazard are enormous.

An Alternative Approach

The alternative model that the RBI should follow rests on three pillars. The first recognises that the biggest source of market and systemic failure is the economic cycle and so regulation cannot be blind and deaf to the cycle. The economic cycle must be put close to the centre of banking regulation. Charles Goodhart of the London School of Economics and I have proposed contra-cyclical charges – capital charges that rise as the market price of risk falls as measured by financial market prices – and a good starting point for implementation of such charges is the Spanish system of dynamic provisioning [Goodhart and Persaud 2008].

The second pillar of banking regulation should focus regulation on systemically important distinctions, such as maturity mismatches and leverage, and not on outdated distinctions between banks and non-banks. Institutions without leverage, maturity mismatches or a requirement for short-term funding liquidity should be lightly regulated – if at all – and in particular would not be required to adhere to short-term rules such as mark-to-market accounting or market price risk sensitivity that contribute to market dislocation. Bankers will argue against this, saying that it creates an “unlevel” playing field, but financial market liquidity requires diversity, not homogeneity. Moreover, incentivising long-term investors to behave long-term will help bankers because it will mean that there will be more buyers when banks are forced to sell.

The third pillar would be to require banks to either self-insure or pay an insurance premium to taxpayers against the risk that the taxpayer will be required to bail them out. If such a market could be created, it would not only incentivise good banking and push the focus of regulation away from process to outcomes, but would provide an incentive for banks to be less systemic. Today, banks have an incentive to be more systemic as a bail out is then guaranteed. The right response to Citibank’s routine failure to anticipate its credit risks is not for it to keep on getting bigger and bigger so that it can remain too big to fail, but for it to wither away under rising insurance premiums paid to taxpayers.

The next stage in the liberalisation of the Indian economy requires the further liberalisation of the banking system under the auspices of effective, modern regulation. The principles underlying the three pillars described above would allow banks to provide risk capital to Indian corporates responsibly and would reduce the boom, bust cycle that is programmed into the current Basle Consensus of banking regulation. The alternative to learning the lessons of this crisis is to be condemned to repeating it.

References

Goodhart, Charles and A Persaud (2008): ‘A Party Poopers Guide to Banking Regulation’, Financial Times, June 4.

Persaud, A (2000): ‘Sending the Herd Off the Cliff Edge: The Disturbing Interaction between the Herd Behaviour of Investors and Market Sensitive Risk Management Systems’, Institute of International Finance, Washington.