The Hindu Business Line : Securities Markets — Regulation lessons for India

Learning the right lessons from the current financial crisis in the US can work wonders for the infant securities market in India, says PRACHI MANEKAR.

The collapse of the sub-prime mortgage market and its consequences on financial institutions in the developed world have lessons for India, not the least because of the loss of investors’ confidence in the securitisation markets across the world. The crisis, whose end is still not clear, highlights the need for greater transparency and accountability in our securitisation market. The collapse of venerable institutions underscores the need for a robust financial infra structure with a vigilant regulator and a vibrant secondary market.

India needs to concern itself with two fundamental issues: First, do we need securitisation; and if so, to what extent should it be regulated? The answer to the first question is clearly an emphatic ‘yes’. Securitisation is undoubtedly an effective source of funding. Its usefulness for our capital-starved banks cannot be disputed; especially so in the run-up to Basel II with stringent capital adequacy norms.

The second question is a little more complex and is best answered with reference to the crisis that provides illuminating lessons. The first is that transparency and continuous disclosures are the key to reviving and sustaining the faith of market participants in these markets.

In the US, the disclosures were adequate. It was the inability of the investors to gauge the magnitude of risk in complex instruments that resulted in heavy dependence on the ratings with results that are now fairly well documented.

New and more complex financial instruments require more comprehensive disclosures to gauge their risks. Since the Indian market does not have any regulations governing disclosures, the RBI should issues guidelines prescribing prominent disclosure of all risk factors associated with security receipts in the issuance documents.

The standards for such disclosures should be as high as those of public offerings. This will reduce asymmetric information and thereby lower dependence on ratings. Such measures will revive the confidence of market participants.

The need for periodic disclosure of exposure to shareholders cannot be stressed enough, especially in the backdrop of losses disclosed by Indian banks. Securitised items find only a passing reference in the annual reports of banks and financial institutions that gives them an opportunity to dress up their financial statements.

It is desirable to insert a ‘Statement of Risk and Exposure’ in bold letters in the financial statements. The institutions should clearly explain the nature of exposure to various financial instruments and the risk associated with them. Making such disclosure mandatory will make financial reporting more accurate and reliable.

Containing counterparty risk

The securitisation deals that have now soured were largely bilateral; at times, they were insured by bond insurers. The sub-prime market was a small segment of this securitisation market. As the crisis set in, neither the protection seller nor bond insurers could honour their commitment, leading to a series of defaults.

The domino effect is a systemic risk that sets in when one party is unable to honour its commitment to the other, which, in turn, is unable to honour its own commitment. The resulting chain of defaults damages the financial system incalculably and the risk is no less potent in the Indian securitisation market.

Establishing a vibrant secondary market can greatly mitigate this risk, as the IMF observed in its 2006 Annual Global Financial Stability Report. It clearly stated that credit derivatives offer financial stability only if a more liquid secondary market is developed for the protection sellers.

That secondary market for securitised products is virtually non-existent. The responsibility is cast on the RBI to take special efforts to create deep and liquid secondary markets. This market should be open only to restricted players, similar to the money market.

Policymakers can even consider establishing an intermediated exchange for credit derivatives which can negate counterparty risk. However, the incremental costs of intermediation should not override its benefits.

Streamline mechanism

Not just banks but credit rating agencies too took the flak for the crisis in the US as the confidence reposed in them was badly shaken when investors holding senior tranches, with triple-A rating (supposedly the safest), were called up for payment. These agencies failed to give even a prior warning to such investors in the form of downgrades. Their failure to do so has been found in the conflict of the interests and oligopolistic tendencies prevalent in the rating industry. Many attributed the failure to the difficulty in pricing risk of complex instruments.

So far, the RBI has issued guidelines only for regulating credit enhancement mechanism. It should actively consider a list of best practices for the credit rating agencies. Regulators worldwide are considering the pros and cons of issuing comprehensive regulations to regulate credit rating mechanisms. Apart from other benefits, such regulations would effectively reduce the issuers’ desire to shop for better ratings.

We also need to spearhead ongoing research with premier institutes for refining models of pricing risk; especially the risk in complex financial products. This will reduce subjectivity, and consequently reduce frauds.

Excessive leveraging can prove disastrous

The sub-prime crisis created a ripple effect of such magnitude that it affected financial markets across the globe; excessive leveraging exacerbated this crisis.

Given the level of integration in the world financial markets, containing the ripple effect can be a daunting challenge. The RBI has tried to mitigate this risk. In its regulations issued in February 2006, it prescribed prudential norms for investments in SPVs (Special Purpose Vehicles). However, more needs to be done.

Comprehensive regulations setting exposure limits for all market participants are desirable, even if they incur the displeasure of the participants. Protecting the financial system is more important than pleasing any one set of players in it.

Dynamic markets

Securitisation always was (and still is) a market with tremendous scope for financial engineering. US regulators have been blamed for not keeping pace with the developments and failing to take timely action to avert the crisis.

The Indian securitisation market is still in its infancy with volumes around $6.25bn; this is insignificant compared to the US, where volumes are as high as $28 trillion. However, our market is rapidly maturing, growing at a phenomenal pace of 120 per cent annually.

So, while such regulators as the RBI, SEBI, and the IRDA need to be constantly vigilant and modify policies for the particular stage of market evolution, they have to ensure the timing. An overdose of stringent regulation could strangle the infant while trying to alleviate its ills.

(The author is a SEZ Consultant, Mau’s SEZ Solutions.)

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