The dominance of the Big 3 ratings agencies and the Big 5 investment banks continues
T decade after the financial crisis permeated the veins of the financial structure of the world economy, some very interesting observations can be made. The financial crisis involved the adverse impact of financial engineering that typified the sophistication in the financial market where loans given for housing were repackaged and sold to investors (CDOs). More important, a consequence was that the originator and ultimate lender were different and not identifiable. A fall in the real estate market led to large-scale defaults where homes were confiscated, but had, by then, diminished in value. Markets collapsed as institutions went under.
Some were allowed to perish while others resuscitated. As banks stopped trusting each other and governments cut back on expenditure, central banks invoked ‘quantitative easing’ to revive their economies. This involved giving cash in lieu of securities that were not necessarily government bonds. BIS came in and introduced the Basel III norms that involved liquidity requirements. Regulation everywhere intensified and today the financial market seems more secure, or appears to be so.
But this entire process has been quite peculiar. First, the world economy is not quite back on its feet post-Lehman. While the US economy recovering has caused the Fed to increase interest rates, the picture across the major economic blocks is not clear. It is true, post-Lehman, the sovereign debt crisis emanated independently, changing the equations besides causing some disruptions in the form of Brexit and Donald Trump’s elevation as president of the US—where the approach to economic policy is now more aggressive and different from those pursued by his predecessors.
Second, while the financial crisis did lead to strong regulation across all countries, the domination of the super powers in credit rating and investment banking has not changed. While regulation spoke of having more competition in specific market segments, ironically, stronger regulation put up barriers to new players coming in as the regulatory cost became prohibitive. It was much simpler for the larger institutions to comply with the new regulatory structure as the cost could be absorbed by them. Therefore, the big three in the ratings business and the big five in investment banking continue to reign supreme.
Third, post-Lehman, the focus on inequality and governance caught public attention, with Thomas Piketty Capital in the 21st century setting the tone. The principal agent relationship that was first enunciated by Adam Smith stood even more clearly exposed as CEOs earned their income and bonuses through all the wrongdoings associated with the crisis, but didn’t have to pay for the same. Some continue to rule, rewarded with fat pays. The asymmetric reward pattern exists even today. Not surprisingly, there is a move for more government everywhere and this kind of social proclivity is something which Karl Marx would have been happy with.
Fourth, as a corollary, those responsible for the crisis went free while the policies pursued by governments aimed at cutting expenditure and better fiscal management, especially in the European countries, meant that the poorer sections suffered as allocations for social schemes came down (especially in the PIGS nations) as part of the packages recommended by IMF and European Commission. This is unlike in India where the NPA crisis has meant that several bank heads have been under investigation.
Fifth, for the first time, central banks gave liquidity to banks and financial institutions by exchanging corporate bonds like ABS and MBS for cash. OMOs normally involve government paper, but, in order to restore trust among players, it became necessary to provide liquidity against commercial instruments, which is probably the first of its kind. This happened across all developed countries to instil confidence in the players which held on to these instruments. Interestingly, at this time the LIBOR controversy also erupted where banks tended to understate their polled LIBOR rates to send incorrect signals to the market that all was well. The unmasking of this wrong-doing has helped to bring about a more regulated price discovery in the market.
Sixth, curiously the liquidity that was provided by the central banks did not go into lending internally for furthering investment. Growth remained depressed for the larger part of the decade. The money instead went to the EMEs that witnessed an upsurge in foreign inflows that in turn helped to boost their markets and currencies. A consequence was high level of monetisation in these countries and central banks had to sterilise these flows through absorption tools like the MSS bonds in India to keep the rupee (currency) steady.
Seventh, while QE was a bonanza for the recipients, it also meant that when these flows would stop, the reverse processes would be set in motion. Hence, the US decision to roll back QE and bond purchases (which the ECB is doing as well), caused EMEs to convulse at the prospect of FI flows slowing down. Subsequent increase in interest rates in the West has meant that the FI flows have started to move into the trickle mode, affecting all countries and currencies.
Eighth, countries have become inward-looking, starting with the US and the UK. When the global crisis threatened to degenerate into a 1930s-like Depression period, countries worked towards defending their economies by becoming less open in terms of trade. The WTO remains fairly irrelevant today and controls on imports have been the main policy thrust. The days of free markets and free trade are virtually done, and, while it is not as bad as the ‘beggar thy neighbour’ of the Depression era, it is ‘domestic economy first’ jingoism that is the order of the day.
Ninth, the smug explanation given in the past of the EMEs being decoupled from the world economy and establishing their power to drive forth the rest of the countries have been diluted. China has been at the forefront of being the target for all the inward-oriented policies of the West. With the focus now on teaching China a lesson through countervailing duties, the edifice of this story has been weakened considerably.
Tenth, post-Lehman and the euro crisis and an unrelated development of Brexit, the dollar has regained its hegemony and world still moves on this basis. The euro is struggling to stay relevant as there are pressures individual nations fare facing within their jurisdictions to move away. While the currency will hold, the final hurrah would be Trump’s as the dollar remains the anchor currency.
The Author is Chief economist, CARE Ratings Views are personal