D. Murali

Chennai: What is ‘liquidity crunch’ that is in great focus these days? Why is it a problem? Where are its roots? What is its magnitude? Do we have examples of such a crisis in our history books? These and more questions are currently top on the minds of most of us.

“Liquidity crunch is a situation where it becomes considerably difficult (and expensive) to raise funds for banks as well as for businesses,” explains Mr N. Muthuraman, is former Director-Ratings, Crisil Ltd. “At present, we are witnessing liquidity crunch both in global and Indian credit markets, though for very different reasons,” he adds, during the course of a recent email interaction.

Mr Muthuraman, an engineer and a management graduate from IIM, Bangalore, is the Co-founder of RiverBridge Capital Advisors Pvt. Ltd, a financial consulting and investment banking firm with focus on assisting SMEs (small and medium enterprises) to access mainstream capital sources including venture capital, private equity and strategic investors.

Excerpts from the interview.

How different are the reasons for liquidity crunch in India, as compared to the global scene?

The liquidity crunch that is playing out in the global markets is a result of crisis of confidence among banks. The collapse of large banks and financial institutions such as Bear Stearns, Lehman Brothers and AIG has shaken confidence of banks to freely lend to each other, as everyone is guessing about who is next. As a result, many banks which relied on short-term wholesale funds from other banks, are finding it difficult to raise such funds any longer, leading to a liquidity crunch.

The roots for this crisis can be traced to securities invested by banks that are backed by sub-prime mortgages. Sharp erosion in value of such securities and lack of transparency (about the quantum and nature of such toxic assets that still remain in various banks’ books) are the main causes for the crisis of confidence in global markets.

In contrast, the liquidity crunch in Indian markets is largely a localised and short-term phenomenon, triggered by factors such as advance tax payments, regulatory intervention in forex markets to stabilise the depreciating rupee, etc. There is some rub-off effect of the global liquidity crisis on India as well, because foreign institutional investors are selling domestic equities exacerbating pressure on rupee. However, this has only a marginal impact on liquidity; there is no crisis of confidence among banks in India to lend to each other, as is being seen in global markets.

Every country has gone through liquidity crises in the past – for instance the US in 1998 during the LTCM (Long-Term Capital Management) collapse, Egypt in 2001, the UAE (United Arab Emirates) in recent times have all seen liquidity crises. However, the simultaneous occurrence of this crisis in all major financial markets and the magnitude make the current crises the most severe one in anyone’s living memory!

Can you tell us about the countermeasures to tackle the liquidity crunch? To what extent will the current steps taken by the central bankers (such as reducing the CRR) help?

To tackle the liquidity crunch in the Indian credit markets, the CRR (cash reserve ratio) cuts announced by the RBI (Reserve Bank of India) in recent times are welcome moves, as these infuse the much-needed liquidity into the banking system. As I said earlier, the liquidity crisis in Indian markets is temporary, and I believe the move by the RBI is sufficient, at least for the time being, to ease the liquidity pressure. Moreover, the regulator still has significant lee-way in managing the domestic liquidity well, though this may interfere with its efforts in containing inflation.

In contrast, the measures taken by global regulators still lack clarity, and have not yet eased the crisis of confidence among banks despite repeated attempts to inject liquidity.

In my view, getting to the root of the problem, viz. forcing all banks to simultaneously disclose all their sub-prime related exposures and losses (both on and off balance sheet), and significant direct capital injection into the weakest banks will be the most effective way to bring back confidence among banks to freely transact with one another. Other indirect measures, such as guarantee of all inter-bank transactions, or lowering rates have not yielded any results so far and may only prolong the current crisis.

Over the recent weeks we are getting used to reading about big bankruptcies and mega institutional failures. Were these avertable? Also, should there be major rescue efforts in the face of imminent failure?

Though the current crisis looks highly complicated with new acronyms being thrown around every day – RMBS, CDO, CDS, etc. – the basic problem has been reckless lending, a fairly well-documented problem that has caused innumerable financial sector crises worldwide. I am sure most of the market participants as well as regulators were fully aware of the problem of reckless lending to borrowers, who otherwise will not qualify for a home loan in normal times.

What no one understood is the number of hands the mortgage changed hands through innovative financial engineering and securitisation, and how far and wide across the globe, such assets were being held by otherwise risk-averse institutions. These instruments have been instrumental in transmitting the effect of default on housing loans in the US to the failure of banks in Iceland and insurance companies in Japan.

While the crisis could not have been entirely averted, a few prompt regulatory responses could have minimised the magnitude of the crisis. Some measures to control the sky-rocketing US house prices, which formed the fig leaf for the reckless lending, could have been taken.

In sharp contrast, the RBI has been very prompt on this count. Avenues for fund-raising by the real estate companies were gradually closed when asset prices increased rapidly in India. Higher risk weight for real estate exposures of banks, closing the ECB (external commercial borrowing) windows for real estate companies, tighter norms for lending based on land value, etc., had a salutary effect on the rising real estate prices in India.

Other global measures to avert a repeat of such crises can include prudential norms on exposure to securitised assets, prompt disclosure of the nature, quantum and current valuation of such complex assets and timely response to any crisis of confidence to ensure that the situation does not go out of control.

That brings us to the second part of the question. Should public money be used to rescue private financials institutions? This is the classic regulatory dilemma. Saving banks may lead to a moral hazard of encouraging banks to take more and more risk, on the comfort that the regulator will bail them out if ever there is a trouble. On the other hand, not acting timely could easily escalate the problem beyond control. Banking system needs large doses of confidence to run their daily business. If depositors are nervous, that makes banks nervous. In turn, banks could freeze lending to businesses and individuals, leading to a tailspin of recession.

Weighing both sides of the argument, my view is to support prompt government response to bailout packages. At the same time, regulators should ensure that the bailout process is punishing enough for the management and the equity investors, to leave lessons behind that it is not business as usual if an institution is bailed out using public funds.

Are there ways to know an oncoming credit crunch beforehand? What are the lead indicators?

There are a few indicators to forewarn the market participants about an impending credit crunch. The widening gap between inter-bank borrowing rates and risk-free treasury bills could be a signal that banks are unwilling to lend to each other without fear of losing their money. Widening credit spreads for businesses could also provide vital clues of an impending credit crunch. But these are all tell-tale signs when the regulator shifts gear to adopt a tight monetary stance to reign in inflation.

At the corporate level, what do you see as the key factors the CFOs should now focus on?

Key priorities for a corporate CFO (chief financial officer) now are maintaining healthy liquidity, reassessing capital expenditure and funding plans assuming higher cost of capital, and finally, widening their portfolio of bankers, rather than relying on a single bank. A corporate that is in the approved credit list with many banks, is likely to tide over a liquidity crunch more easily than corporates dependent on single bank. It may also be prudent for a CFO to rely less on debt in turbulent times like these.

Banks and insurance companies are generally perceived to be the best and the most regulated organisations, adopting best practices, be they Basel II or risk management systems. If that were the case, how did failures of the scale we now see come about? Have the systems conked?

In my view, Basel II has focussed excessively on credit risk aspect in a bank’s books and has glossed over market risk. This approach works well for traditional banks, whose main business is to make loans. On the other hand, modern day banks have much more complex instruments in their books, where market risk poses greater threat than credit risk. New measures to scientifically assess market risk and also elementary prudential norms in restricting the extent of leverage to say 10x or 15x, irrespective of the composition of assets, may be needed to strengthen the banking system.

Generally investors keep thinking about good returns. Now they are worried even about their capital, and wondering whether they should keep money in one bank or the other, or rather as cash! So, what is your advice to investors like the senior citizens and the risk-averse who look for safe returns?

Banking sector in India is very safe. The banks in India are well capitalised, have strong deposit growth, healthy liquidity and good profitability. While there are some concerns on asset quality, these are still quite manageable as the banking system NPAs (non-performing assets) are currently at their lowest level in the last decade.

More important than these, banking sector in India is well-regulated. For instance, timely action by the RBI has helped contain real estate exposure and equity market exposure of banks. Even securitisation has not assumed large proportion in Indian banking system, and credit derivatives are absent, unlike as in other developed markets mainly because of the cautious approach of the regulators.

The RBI has also come out strongly assuring liquidity in the banking system, to restore confidence of the common man. I believe these are adequate to maintain the health of the Indian banking system and hence, there is no need to panic about the safety of deposits in Indian banks.

In fact, a classic ‘flight to quality’ in turbulent times is happening as investors are moving funds from FMPs (fixed maturity plans) and other mutual fund products into bank deposits in recent times, which is clearly a vote of confidence in Indian banks among the investing public.

The stock markets have been extremely choppy. Where do you see things heading to?

This is the most difficult question to answer! I am not ready to speculate on which way the market is headed on Monday or Tuesday! But, if you detach yourself from the day-to-day volatility, the equity markets today appear attractive for long-term investors to build a life-time portfolio. Markets may or may not have bottomed out yet, but retail investors, or for that matter any investor, may not be able to time the market perfectly. However, a systematic investment in equity over the next few months could help investors tide over the volatility.

**

InterviewsInsights.blogspot.com