Learning From Crisis

Over time we have moved from commercial-bank centred, highly regulated financial system, to an enormously complicated highly engineered system. Today much of the financial intermediation takes place in markets beyond official oversight and supervision, and involves highly opaque engineered derivative instruments.

The complexity, opaqueness and systemic risks embedded in the new markets have led to unravelling of mutual trust among market participants. Simply stated, the new financial system has failed the litmus test of a marketplace. The heart of the problem is the inherent risks involved in financial intermediation, which requires that those who need funds are able to acquire the same through a financial intermediary or the market. The fund providers insist upon safe, highly liquid outlets for their money. Reconciling these different requirements involves uncertainty and risks, that is, credit, maturity and liquidity.

Managing these risks was once largely the role of commercial banks, savings institutions, insurance companies, which had an official safety net (central bank) in times of stress. In the new paradigm, the intermediation process has become the domain of the open market. The general idea being that risk can be minimised by unpackaging institutional relationships, separating maturity and credit risks, and creating instruments that would meet the needs of people willing to absorb these risks. The rationale was to encourage better pricing and distribution of risks. Efficient in theory, but in practice creating unimaginable complications because of the lack of responsibility of a lender for ensuring credit worthiness and inability to assess the capability of a purchaser in the secondary market to appraise the nature and value of the credits it was requiring.

The combination of herd behaviour, opaque loan characteristics and breakdown of market functions at times of crisis requires a complete new assessment of market participants and their functions. Going forward, deciding on the proper structure for the financial sector is easier if you have a clear idea of what you are financing. India is a rich/poor country. Consequently our financial sector will need the sophistication of the developed markets coupled with base banking to meet the needs of small-scale manufacturing, farming and services-related firms.

Banking system: The development of India as a rich/poor country is asking the banks to fulfil the role of banks, debt market, venture capital and government. The banking system is doing a good job of meeting the needs of small business, agriculture, large companies, and does not require much repair. The areas to be looked into are the pre-emption of lending capacity through SLR (statutory liquidity ratio) and CRR (cash reserve ratio) and directed lending at directed rates. CRR, SLR and directed rates and lending distort the interest rate structure (yield curve) and impede the creation of a sovereign bond market.

We need to encourage microfinance. And to promote retail lending, we need to create an effective and speedy recovery mechanism, in the absence of which, banks may restrict their lending to middle and upper-middle class.

Markets: We also need developed debt, currency and derivatives markets. Here all we need is more local institutional and retail participation to reduce foreign institutional investor dependence. Development of these markets, as pointed out in the report Mumbai — An International Finance Centre, require:

• A liquid and efficient sovereign bond market with an arbitrage-free rupee yield curve. This would be in line with the objective of a separate debt manager for the government, the government accessing the market for its borrowing and removing the distortion in the yield curve caused by SLR and directed lending interest rates.
• A wide range of essential derivatives on rupee -interest rates. A liquid spot market for rupee- denominated corporate bonds. This requires institutional participants such as insurance companies and provident funds.
• Credit derivatives on credit spreads. Guarantee of corporate debt by banks to help institutional investment would be a good beginning.
• A liquid currency market. Full range of currency derivatives. Allowing banks to participate in non-deliverable forward (NDF) market.
  
  
  In conclusion, we need to focus on composite solutions across the economic spectrum to ensure we meet our potential for GDP (gross domestic product) growth.
  
  The author is managing director of HDFC Bank

(This story was published in Businessworld Issue Dated 28-12-2009)

---