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Fallout of the sub-prime crisis financial scene

The next of Citibank’s CEO Charles Prince on November 4 and of Merrill Lynch’s CEO Stan O’Neal a week earlier might have been the high point of the ongoing sub-prime and credit crisis but it does not by any means end the accountability debates that have gripped both sides of the Atlantic and indeed everywhere.

Both took responsibility for the major losses to their institutions on account of their deep involvement in the housing loan crisis. There were pressures from shareholders and outside (independent) directors as well.

Both the CEOs did not march into oblivion, unsung or derided by their peers and their shareholders. Both received healthy severance pays even as the institutions they led received hard knocks. The respective boards had acknowledged their contributions.

The Citigroup’s board recorded “its tremendous support and respect” for the departing CEO.

Until the sub-prime crisis manifested itself so menacingly, there were apparently no checks and balances to rein in practices that later proved disastrously wrong. While the assumption of responsibility by the top person is understandable, it is surprising how the rest of the top management as well as the board of directors and other employees have escaped scrutiny, at least so far.

As the crisis rolls on engulfing the broader credit market, there are definite indications that it has acquired all the characteristics of a systemic risk calling for co-ordinated action by the policy makers. Banks such as Citi are forced to provide additional capital to meet the large write-offs. Ominously their existing method of valuing assets on their books looks weak. Since they hold huge amounts of collateralised debt obligations and other inherently opaque instruments, their methodology to fix a value was questionable even in normal times. In crisis times they were found to be no more than inspired guess estimates.

Banks with lesser capital would obviously lend less to the more productive sectors. It is not just the housing sector but the whole economy that may suffer for want of bank loans. The fact that two interest rate reductions by the Fed have not been enough to stimulate the American economy has its own story to tell.

Given the strong linkages that the U.S. economy has with the rest of the world, the sub-prime crisis is destined to be a global problem with strong ramifications for all countries including India. For now, the key area of interest is in comparing developments in the U.S. and here after a major crisis in the financial sector has been revealed. As pointed out, a crisis of the sub-prime magnitude may not hit India. The last “systemic” crisis that comes to mind is the securities scam of 1991-92, a good 15 years ago. In many ways that crisis still lingers with the legal process of fixing responsibility and recovering money from the likes of Harshad Mehta dragging on and on.

The crisis in the U.S. will become worse before it gets better. However, the way the affected institutions are facing their problems head on is noteworthy and holds important lessons for all.

Since capital adequacy of the Citigroup was impaired, one of the first actions of the new management was to raise funds from whatever sources. Last week Citibank sold a 4.9 per cent equity stake aggregating $7.5 billion to the Abu Dhabi Investment Authority which now becomes its largest shareholder.

Until now that position was held by Prince Walid Bin Talal of Saudi Arabia. Hence the first two top shareholders of the Citi group are from West Asia.

In India, ensuring capital adequacy is a big issue for local banks, especially in the run up to Basel II. Large public sector banks which still dominate the banking landscape are contemplating various ways of getting capital. Their real constraint has been the government ownership. There is no way the Government is going to permit a lowering of its shareholding to below 51 per cent.

The RBI in its Trends and Progress of Indian Banking has underlined the urgency to raise additional capital at a time banks are lending more.

The point that even without a crisis, Indian banks require additional capital which they are unable to raise through any of the conventional routes.

A “strategic sale” of a large chunk of shares to an investor cannot be countenanced in the present milieu. After the securities scam, although several government banks were involved, capital adequacy was not an issue. One reason of course is that it was only after financial sector reform (that began in the early 1990s) that the RBI and the Government called upon the financial sector to adhere to internationally accepted norms in accountancy. Capital adequacy, income recognition, asset classification, provisioning and so on were to come later.

Of course, the biggest difference between the U.S. and India is not necessarily in the size of the financial sector. The Citi group is no doubt several times bigger than the State Bank Group. Its involvement in the sub-prime crisis may be much larger than all of SBI’s problem loans. Yet the American bank’s CEO was not summarily sent home as M. N. Goiporia, the then SBI chief M. N. Goiporia (in the 1990s). He died a few months after demitting office without ever getting an opportunity to prove his non-involvement. The fate of many other officials in the SBI group and other government owned banks was much worse. Many have died and 15 years on there seems to be no end to their legal travails.

There is obviously no level playing field between the public sector banks and the foreign banks.

There was no equality 15 years ago. Foreign banks including Citi and Standard Chartered were held to be the main perpetrators of the scam by no less than the JPC. But no foreign bank official, big or small, has been held responsible by the courts. There are many other differences now as there were then between the financial sector in the U.S. and India.

C

. R. L. NARASIMHAN

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