The Hindu Business Line : Tremors in financial markets: A problem of plenty

To mitigate the risk of increased delinquency, the Indian banking sector would do well to put quality before quantity and not depend on higher interest rates.

M. Sitarama Murty

The ambers in the sub-prime fire continue to simmer, erupting like a volcano now and then. The Citi Group’s reported loss of over $9 billion is one such flare, the total market losses estimated to run into hundreds of billions of dollars. When an earthquake occurs the epicenter is quickly identified. The ‘how’ of it is also explained as movement of the earth’s crust along the fault lines. But the ‘why’ of it always remains a mystery. For the present crisis the epicenter has been identified as the sub-prime crisis. But the fault lines are yet to be located.

Several international financial institutions, badly bruised in the crisis, are still licking their wounds and are clueless about the final outcome. Availability of credit for even genuine productive purposes has been scarce despite pumping in of funds and assurances of support by central banks. Confidence level remains low. President Bush had to announce that for five years to come the sub-prime interest rates would be frozen, highlighting the uncertainty prevailing in the markets. A loss of such magnitude (Rs 40,000 crore) in India would have shaken the foundations of the financial system.

Not much difference

At the first sign of default or sickness the tendency has been to foreclose all options and enforce recovery or write-off the loan. In the Indian market the scenario is not much different. Inaction, induced by the welfare-oriented loan melas and directed lending, was the norm for decades. To combat the bulging NPAs problem, a quick fix solution of write-off was found handy during the 90s, particularly in the PSBs. Only after the SARFAESI Act came into being, banks found reason to tackle recoveries through coercive and legal action.

In the case of sub-prime loans it is not clear as to what steps have been taken, if any, to enforce security. The real estate or housing markets in the US and Europe, where the crisis has its roots, haven’t crashed either. Though servicing debt might have been a problem for the NINJA borrowers (No income, no job), the last letter ‘A’ now seems to symbolise ‘no assets’.

Loan appraisal systems

Then questions arise about the quality of mortgages and the assets. If the rating agencies, which mostly go by the records, failed to protect the investors, the loan appraisal systems seem to have to have failed the banks.

That the banks were able to write-off such huge amounts in the first place, prompts a lay man to think that the institution/s were making huge profits fleecing the customers, leading to such situations.

Though the investors have reportedly lost a third of their investments, for salvaging the situation, there is a case for a massive rehabilitation package of concessions and rescheduling. If the investors are left in the lurch, the financial markets would have to face further upheavals.

Unanimous view

Analysts seem to be unanimous that the crisis is an outcome of problem of plenty. With the markets flush with liquidity and mandates to maximise income and profits, all the time the financial whiz kids have to look for new opportunities and churn out innovative products to attract investors.

‘Collateralised debt’ was one. Money in circulation has a multiplier effect. But creating money out of nothing, defying the fundamentals of science that matter can neither be created nor destroyed, seems to be an innovative idea. Creating wealth through production or trade of goods and services is old fashion. Speculation is the in thing.

Financial engineering appealed to many when derivatives such as forward contracts, options and futures were introduced to protect margins against uncertainties. Regulators too gave a measure of freedom to provide depth to the markets. Innovation graduated from being a mere hedging technique to a tool for maximisation of profits. While the underlying securities remain the same, the volumes traded in money, forex, stock and commodity markets are mind boggling.

Land mines

If the stock markets boom, the managers of the economy are happy. It is considered an index of confidence of the investors. The level of productivity or production of goods and services or the dividends on shares has no relevance to the multi-fold jump in the index. Cough syrup is a common household remedy. Persons looking for some thing new and different all the time found an alternative use for it, changing its character. The derivatives, meant to manage risks, have themselves become land mines.

All over the globe the pay packages have gone up multi-fold. Corporate profits are soaring. The surpluses have to be parked in profitable investments. The pressure to invest and increase income only gets compounded.

Only for the ‘haves’

To improve standards of life and generate employment, spending as well as investment have to increase. An element of inflation is inevitable. But human ingenuity results in generating surpluses hundred-fold only for the ‘haves’, while the 95 per cent ‘have-nots’ continue to remain vulnerable. The benefits of decades of progress can be wiped out in one major financial catastrophe.

Banks that have engaged agents for recoveries faced the wrath of the judiciary as well as the RBI, in the recent past. Surprisingly the RBI, knowing the markets too well, reacted rather sharply, coming out with a code for recovery. The tightening of the recovery mechanism seems to have resulted in higher interest rates. This is not a positive response. To mitigate the risk of increased delinquency, the Indian banking sector would do well to put quality before quantity and not depend on higher interest rates.

(The author is a former Managing Director of State Bank of Mysore and can be emailed at murthy@mandavilli.com).

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