This year has seen a major upheaval in global finance. It will prompt a rethinking of many traditional views about how finance can be made to work well. In 2008, we have once again learned the critical importance of deposit insurance. The job of deposit insurance is to ride forth into the battlefield when things are going bad and find the wounded soldiers. Banks have to be laid to rest before they become insolvent, before they can induce trouble for the rest of the economy. The hero of the crisis was the US FDIC, which was the quiet overseer of the death of more than a dozen banks in such fashion through 2008. In the UK, weaknesses of deposit insurance were one factor which led to the Northern Rock crisis. The UK is now likely to build a US FDIC-style structure to cope with failing banks. As the Rajan committee has emphasised, India also urgently needs fundamental reform of the DICGC, which is (at present) merely a department of RBI that pays out money to depositors when a bank goes bust. Deposit insurance premia are also likely to go up significantly worldwide, reflecting this renewed awareness of the vulnerability of banks. More generally, there are now renewed concerns about the difficulties of banking. Banks give assured returns with full liquidity to depositors and put the money into opaque and illiquid assets, with very high leverage. As an example, the leverage of PSU banks in India is 20 to 1, while the leverage with index futures trading at NSE is 6 to 1. This combination of five difficult factorshigh leverage, opaque assets, illiquid assets, assured returns to depositors and full liquidity to depositorsis a daunting one. For this reason, banking has been a disaster-prone industry for centuries. Hence, there is a case for public policy to exert subtle levers of influence and bias the country in favour of a securities market-dominated financial system rather than one in which banks are an important part.

Turning to securities markets, the major lesson of 2008 is the vulnerability of OTC contracting, where counterparties talk to each other on the phone or on a chat system, where the transparency of an exchange is absent and where there is counterparty credit risk. When Bear Stearns approached death, the US Fed was forced to help JP Morgan buy the firm owing to the repercussions in the OTC market where Bear Stearns was active. When Lehman died, repercussions in OTC markets were Lehman was active were critical in generating panic. The collapse of the money market in London and New York was critically about the use of OTC contracting on this market.

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For India: reconfigure regulation

In India, for more than a decade, RBI has championed a big role for OTC contracting, driven by considerations of turf: exchange-traded products are regulated by Sebi, while the vaccuum in OTC contracting has been utilised by RBI to grow its influence. Wise men in India have long warned about the problems of OTC contracting. The Percy Mistry report has an extended rumination on why it makes sense for India to emphasise the discipline and safety of the exchange and the clearing housewhere trading takes place with the transparency of a fish tankas opposed to the great wide ocean of OTC contracting.

The currency futures market is a litmus test of how much RBI has learned. So far, it seems that RBI has learned nothing, for the transparent currency futures market is hobbled by restrictions while the opaque OTC currency trading gets a free pass. Those who fail to learn from history are doomed to relive it. The third key lesson concerns the fragmented and byzantine regulatory architecture of the US which led to failures of financial regulation, particularly of home loans. The US Fed is ultimately a central bank and is not focused on financial regulation. In a structure with multiple regulators, a lot of regulation was getting done but the right things were not getting done. It is a telling comment that in the UK, Northern Rock ran into trouble when its funding on the money market dried upbut Northern Rock had an NPA rate of only 2%. The UK model delivered sound practices at Northern Rock for giving out home loans as opposed to the US model. Fundamental change in regulatory architecture in the US might now come about. The rules-based SEC might be merged into the principles-based system. Banking and insurance regulation might come into unified agencies. In India also, there is a substantial task of clarifying regulatory architecture. Market functions of RBI need to be placed at Sebi. Banking regulation needs to come out into a separate regulator.