Crises-financial or otherwise-sometimes provide opportunities and the necessary political climate for much-needed change. However, long-term strategic thinking is probably best done free from the pressures of an ongoing emergency. It is in this light that one must view the influential report that Lord Adair Turner, head of the Financial Services Authority (FSA), London?s apex financial regulator, has presented in March.
The report is part of the inescapable soul-searching in a country pretty much at the center of the current crisis, trying to make sense of what went wrong and recommending the best measures going ahead. Its analysis of the causes of the current turmoil, if not entirely novel, is very cogently and concisely argued. The global macroeconomic imbalance, a matter of concern for much of the current decade, lies at the heart of things. Massively current account surplus countries like China have funded, mostly through investment of central bank reserves, consumption in deficit countries like the US. Given that this investment has been largely in government bonds, it has kept interest rates at very low levels, spurring credit extension and property price booms in some developed countries. Further, such low interest rates triggered a demand for financial innovation, resulting in the slightest yield improvement, leading to an explosion of securitised assets. Problem arose when these securitised products, instead of being held by end investors prepared to hold them till maturity, ended up largely in the balance sheets of highly leveraged banks and bank-like institutions. Borrowing levels within the financial sector?that is amongst financial firms?ballooned in recent years, raising risks of the sector as a whole, accentuating both the boom and the bust that followed. Leverage soared, particularly on the back of trading activities requiring much less capital than banking. Widespread use of the ?value-at-risk? (VAR) approach and the procyclicality induced by a complex maze of credit derivatives depending on underlying credit ratings all raised the stakes.
The review unambiguously points at regulatory gaps in allowing this crisis. As has been sorely felt recently, global banking has ballooned in recent years without any global regulatory authority?systemic risk implications of large banks as well as cross-border activities have never been fully realised. It is, appropriately for the times, a ringing endorsement of the ?behavioral finance? view. It casts doubt on the very precepts of efficient and rational financial markets, precepts on which financial regulation in most countries, definitely the UK, is based: that ?market prices are good indicators of rationally evaluated economic value?; that securitised credit improves allocative efficiency and financial stability; that mathematical analysis can judge the risk characteristics of financial markets; that ?market discipline can be used as an effective tool in constraining harmful risk taking?; and that market competition can allow only beneficial financial innovation to survive.
Given this diagnosis, it is hardly surprising that the recommendations broadly include fundamental changes in regulatory approach, focusing on capital requirement, accounting and liquidity; basing institutional and geographic coverage on economic substance rather than legal form; a ?more intrusive and systemic? approach to supervision; a distinction between ?utility banking? and ?casino banking? in regulating banks; as well as greater regulation and supervision of cross-border banks. More ?macro-prudential? analysis by regulators is advocated, with a regulatory focus shift towards high impact businesses, by focusing on business models, strategies, risks and outcomes in the supervised companies.
Broadly speaking, UK?s famous light touch, principle-based regulatory approach is undergoing a tectonic shift and financial firms must now be prepared for regulators to keep peeping over their shoulders. Given the mess the sector has landed itself in, there is hardly any room to argue against the reverse swing of the pendulum. The only thing to remember is that the crisis has probably spectacularly corrected the errant players already and clamping down on those that survived?often as shadows of their former selves?would hardly yield much in the immediate run. The review is clear about that, its focus is not crisis management but rather thinking ahead for a future framework that would avoid a repetition of this problem. There is a bit of a timing issue here. Being in the middle of a ?perfect storm? is probably not the best time to plan the next ship design?we run the risk of ending up with a clunky fortress.
As for India, the report affects a major policy debate. Two recent high profile government committees?the Finance Ministry?s Mistry committee the Planning Commission?s Rajan committee?have argued in favor of a move to the ?principles-based? regulatory system, though with necessary caution and gradualism. Although one can scarcely blame the principle-based regulatory system for the crisis?rule-based US is no better off?Turner?s U-turn in the temple of principle-based regulation has certainly made their case that much harder to argue.
The author teaches finance at the Indian School of Business, Hyderabad