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Growing complexity of financial sector

— PHOTO: AP

STEMMING THE ROT: A man walks out of Bear Stearns in New York. The Federal Reserve invoked a rarely used depression-era procedure to bolster troubled Bear Stearns and said it would provide even more help to combat a serious credit crisis.

Even as the U.S. economy moves towards a full blown recession there are not many who understand the underlying factors and certainly not the role played by the country’s financial sector. That some of the world’s biggest names in banking and finance could, individually and collectively, were behind a crisis of such a magnitude, with far reaching consequences for the U.S. as well as the global economy, may seem far fetched even now. Yet that is precisely what ha s happened.

The sub-prime crisis that first surfaced in July last has rapidly spread its tentacles across the financial sector. Credit markets of the developed world are virtually frozen and stock prices across the globe have plunged.

There has been unprecedented volatility on the bourses. One major American investment bank, Bear Stearns, has collapsed and there are persistent rumours that all may not be well with a few others.

Official response to the crisis has been anything but patchy. The implicit belief that markets will correct themselves has been given the go-by.

As part of its aggressive interventionist measures, the U.S. Federal Reserve has been lowering its interest rates in quick succession.

The most recent reduction in the FED funds rate by 0.75 percentage points — the sixth since September 2007 — has brought the benchmark interest rate to 2.25 per cent.

While undertaking several other measures to pump in liquidity and shore up the financial sector the Fed, on its own admission, might have reached the limits of monetary policy.

A strong fiscal stimulus package aggregating over $160 billion is set to go into effect. Whether all these are sufficient to stave off a recession and mend the country’s broken financial sector remains to be seen.

The Federal Reserve also engineered the takeover of Bear Stearns by JP Morgan Chase by virtually underwriting the transaction. In the U.K., leading mortgage lender Northern Rock succumbed to the sub-prime crisis and has been nationalised.

All these steps seemed unthinkable even a year ago.

Leading non-American banks have also suffered in the wake of the crisis. Huge write-offs and provisioning seem commonplace as also steps to shore up capital by inviting investments from sovereign wealth funds and others. Long before the ongoing crisis ends, the financial sector’s landscape in the developed world would have changed for ever.

The root cause for all these — the sub-prime crisis — has its origins in some highly questionable practices adopted by American banks and institutions. Borrowers with poor credit records were lured into taking home loans. These loans were then packaged, securitised and converted into complex instruments that encompassed various types of risks, and then sold to investors across the globe.

During times of ample liquidity, there was no problem in selling these instruments which in any case catered to investors with differing risk appetites. Rating agencies aided and abetted the process.

All these went under the name of financial innovation. Theoretically, there was plenty to be gained. Spreading the risks and tapping other markets for liquidity are a few important ones.

However, the ways these instruments were structured were anything but simple. In the end, complexity did the banks and the system in. A significant aspect of the complexity is the failure of even the leading banks to assess the risks in the products they created.

Those who invested in these seemed to be equally ignorant and everyone including the regulators are unsure as to where and when the risks will materialise.

In hindsight, it seems that some simple, commonsense rules were ignored. Sub-prime borrowers, because of their patchy records, are charged higher rates. The riskier the borrower the higher the interest rate.

There was no way this could be camouflaged by converting these loans into esoteric instruments whose workings nobody understood.

When the defaults on the original loans started piling up, the complex ways in which these products were structured only compounded the problem by transmitting the risks across the financial sector and globally too.

What are the lessons for India? Broadly, state intervention to support failing institutions is not new here. In fact public ownership has been a great help in the recent past.

Indian Bank came out of an extremely bad patch only because it was fully owned by the government.

The government also rescued the US 64 scheme and reconstituted India’s first mutual fund. Indications are that the government will recoup its investment. That the public sector banks have been provided capital by the government is fairly well known.

In other words, there is no dogmatic opposition to official intervention in India.

Should the leadership of the financial institutions of the developed world be accepted? The sub-prime crisis might be the latest, perhaps the most glaring, example of financial engineering going wrong.

Those in India looking to the West for best practices and new tools will be disappointed. And while integration with the rest of the world is a fact, it seems just as well that there are still policy blocks to the unbridled entry of foreign banks.

What about the growing complexity in the financial sector?

At present there is a major stand off between some companies and banks which had sold them derivatives.

Apparently, the betting has gone wrong and companies are being asked to cough up large sums that they have not bargained for.

Companies say that they were not fully informed of the risks when they were sold derivative products, some of which are new to India.

In days to come this is going to engage the attention of not just the two parties but the regulators and the government as well.

However it is not in areas such as derivatives alone that complexity is creeping into Indian banking.

The most routing banking functions can be mystified by bank staff who do not know the basics.

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