The world’s financial markets got shot last week by the double-barrel gun of a massive turnaround in risk appetite for corporate credit, and the US mortgage crisis ripping beyond the subprime segment. All markets, India included, are bleeding from the wounds.
The $5.8 trillion dollar US mortgage market is showing cracks. An index called ABX offers clues into the true extent of the damage. ABX prices mortgage-backed securities across all tranches of the credit spectrum. By the end of last week, ABX prices had crashed across the board—from 5% for triple-A to 15% for single-A. By sub-prime pundit logic, this wasn’t supposed to happen. Clearly, the contagion is spreading.
Last week also saw a complete turnaround in appetite for corporate credit in the US. Scores of debt placements worth billions of dollars have had to be postponed, or shelved outright. The leveraged bond engine that has driven the private equity boom in the past year had its pistons taken out, leaving banks with large chunks of unsold bond paper, whose prices are dropping like stones.
What happened last week was not just an air pocket on the inexorable upward journey of the markets. There are serious systemic gaps that have been exposed. In their 2007 report titled Assessing Global Financial Risks, the International Monetary Fund identified these two areas—mortgages and leveraged bonds—as capable of causing systemic challenges to global financial stability. However, in a note of reassurance, the authors wrote, “Major dislocation still appears to be a low-probability event, (since) stress test shows that tranches rated A and higher would not face losses unless house prices fell 4% per year for five years.” Last week’s ABX price drops have shredded this comfort zone.
Much of this market angst has been caused by new financial instruments: CLOs, CDOs, mortgage-backed securities, credit default swaps. None of these instruments is available in India. And yet, India is not inoculated from these financial viruses. The movement of the Sensex and National Stock Exchange last week showed how we have become part of one truly integrated global financial market.
There are lessons for our regulators from last week’s turmoil. Having strict product controls and regimented regulatory silos doesn’t prevent financial risks from rushing. In an address on risk management recently, Rakesh Mohan said, “Deregulation, liberalization and disintermediation have made financial systems far more interconnected, with possible ramifications for contagion in the event of an exigency in any country. As a consequence, central banks, which were traditionally focused on monetary and banking stability, have increasingly come to focus on financial stability as a key concern in the conduct of monetary policy.”
But it’s not possible for central banks to regulate in isolation. The growth of new products and the culture of designing and distributing risk through new instruments has meant that the entire spectrum of regulatory institutions will have to find ways of coming together.
In a report written in 2000 for the UK Financial Services Authority, titled Plumbers and Architects, Huw Evans wrote of the need for an integrated financial architecture: “The excessive reliance on banks in many financial systems (needs to be supplemented by) the need to develop money, bond and equity markets much more fully: This could reduce corporate leverage, improve corporate governance and by reducing reliance on bank financing make the system more resilient to shocks.”
Rakesh Mohan, in the same speech, conceded, “A challenge relates to the issue of coordination (of) policymaking bodies. Instabilities can arise in any segment of the financial system and not necessarily in segments which are under the domain of the Reserve Bank of India.”
We need an integrated regulatory mechanism that is sufficiently sophisticated to be on top of market activities, while being light enough to allow new products and speculation to abound, with pressure-cooker clauses that allow for deft intervention in special situations. The US President’s Working Group on Financial Markets is a good example. Our own high-level coordinating committee that was set up after the Harshad Mehta scam, can be restructured to act as such a forum.
As market players gingerly boot up for the coming week, the question for India is not whether or not the perfect storm is upon us. The question is, “Are we prepared to handle whatever comes our way, in the form of integrated and flexible regulatory structures?” Unfortunately, the answer does not give much comfort.
Ramesh Ramanathan is co-founder, Janaagraha. Möbius Strip, much like its mathematical origins, blurs boundaries. It is about the continuum between the state, market and our society. We welcome your comments at firstname.lastname@example.org