Column : I-Banks, rest in a different piece

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: come full circle and that conventional wisdom has been replaced by the opposite in 2008.

The risks, however, remain in the system. Universal banks with deposits guaranteed by the Federal government—thus making them low on risk—may use that as a base to take riskier bets after a short cooling off period in the aftermath of the crisis. In fact, it would be more viable to take bigger risks on deposits than on money borrowed from the wholesale money market, which, as has happened in the last few weeks, can completely dry up in the event of a crisis, leaving investment banks and their business models badly stranded.

So, while the current model of I-banking may be past its expiry date, newer models and newer instruments of financial engineering will come up to replace the rusted ones. Regulation, no matter how competent, is unlikely to be able to keep pace with smart financial engineering, and with giant banks as the main players, it is even tougher to keep a careful watch. In any case, evidence from past financial crises shows that regulators and governments, more often than not, end up reacting to events rather than acting in a pre-emptive fashion. That is unlikely to change.

Unless, of course, regulators come down hard, like in India, on the openness of the financial system and the kinds of instruments that can be used. Some may be tempted to ban credit default swaps or collateralised debt obligations but, as we know in India, a licence-permit raj just stifles innovation, dynamism and growth. The political economy of America is, fortunately, unlikely to accept financial repression of this kind. On balance, it is probably worth enduring a periodic crisis—which can be managed—in exchange for higher economic growth and benefits in the longer term.

The term ‘moral hazard’ has been much bandied about in the crisis. One would imagine that the battering shareholders and managers have taken in the bankruptcy of Lehman and the nationalisations of Freddie, Fannie and AIG is enough to warn others about the dangers of imprudence and the unpleasant consequences. So far, no shareholder has got a cash bailout at a premium price.