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Averting excessive risk

Averting excessive risk
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First Published: Wed, Sep 30 2009. 09 58 PM IST
Updated: Wed, Sep 30 2009. 09 58 PM IST
The communique released after the Pittsburgh Group of Twenty (G-20) summit last week showers attention on transnational cooperation to create “strong, sustainable” growth and on cross-border regulation to avoid another economic meltdown.
The run-up to the summit seemed consumed by the need to control pay packages in the banking industry as the rhetoric was about putting an end to the much derided “bonus culture”, which was seen to be at the heart of the crisis. No doubt, the structure of executive compensation should actively discourage greedy behaviour, much less induce reckless risk-taking in pursuit of egregious bonuses. However, regulated pay is unlikely to solve the problem: As demonstrated earlier this year, banks managed to circumvent public ire on bonuses by simply handing out large base salaries in lieu of the bonuses. What can stop such wanton risk-taking?
Economic activities need barriers to dissuade reckless behaviour. “Cost of risk capital” is this vital barrier in banking. Cost of risk capital has two parts: interest rates and capital to be set aside in proportion to risks being undertaken. “Bonus culture”, in fact, is predicated upon and thrives on the low cost of risk capital, allowing greedy bankers to place risky bets with “other people’s money”.
Most central banks, in the last couple of decades, have kept interest rates low, at times with negative real yields. This provided the means to speculate with borrowed funds at almost no cost. This drove asset valuations dramatically higher during the boom years.
The fall of Lehman Brothers drove these asset valuations south as market participants wondered if authorities were serious about keeping losses private and not socializing them. However, events thereafter belied this expectation, as industry after industry was bailed out by taxpayers, with central banks even keeping their printing presses busy. Consequently, market participants have become emboldened to believe in the continued luxury of a complaisant fiscal and monetary policy funded by taxpayers. This has driven asset values north again.
Then there’s the little capital financiers set aside. Lax regulation reduced the cost of risk capital even further. The story of American International Group holding little capital against risky bets placed on credit-default swaps is well documented. At one point of time last year, 27 barrels of crude oil contracts were being traded for one barrel of actual US consumption, as oil price rocketed from $60 to near $150 in the space of a few weeks—all thanks to low margin money requirements in the crude oil futures market and the lack of regulation of private equity and hedge funds.
Central banks the world over, including the Reserve Bank of India, have been relaxing the norms for recognition of non-performing assets, requiring less capital to be set aside against risky assets, thereby reducing the cost of risk capital. The Securities and Exchange Board of India has allowed “foreign currency derivatives” to be traded on stock exchanges by players who have no “underlying” assets or liabilities. That is an invitation to speculate, unless stringent margin requirements are imposed on players without “underlying assets or liabilities”.
No less a luminary than former Federal Reserve chairman Paul Volcker strongly favours restrictions on banks trading in proprietary securities and derivatives “with strong capital and collateral requirements”. He has called for banks to be banned from “sponsoring and capitalizing” unregulated hedge funds and private equity firms.
The G-20 must be congratulated for heeding such advice and showing commitment to better regulation of capital being set aside against risky bets. If individual governments carry through with actions matching the G-20 statement, and raise the barrier to speculate with other people’s money, then reckless risk-taking can be effectively tackled.
Puranika Narayana Bhatta runs a finance and operations consulting firm in Bangalore. Comment at otherviews@livemint.com
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First Published: Wed, Sep 30 2009. 09 58 PM IST