The Indian financial system has relatively been less affected by the global credit crunch. Indeed, the cost of money for corporations and individuals has gone up and banks are not liberally giving loans as they used to do till about two months ago before the Wall Street icon Lehman Brothers Holding Inc collapsed but there is no systemic problem and banks are adequately capitalized and solvent.
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Adair Turner, chairman of the Financial Services Authority, or FSA, that supervises and regulates the entire financial sector in the United Kingdom, attributes Indian central bank’s conservatism in relation to things such as capital account convertibility and the use of derivatives to the safety of the system. He also says the “old-fashioned” liquidity rules in India which calls for large reserve requirements in the form of cash reserve and statutory liquidity ratio have “some value”.
According to the FSA chief, India and China should be included in international bodies that oversee the global financial architecture. According to him, Indian and Chinese banks are playing an increasingly significant roles and “we will have the find ways of widening the participation in the crucial consultation bodies for the world financial system.”
Word of caution: Adair Turner says what India could learn from the crisis is that effective policies can mitigate the dangers in a financial system. Tamal Bandyopadhyay / Mint
In an exclusive interview with Mint, his first to any Asian newspaper since he took over in September, Turner talks about the failure of FSA in spotting the problems in the financial system, redesigning the bonus packages of financial sector employees and market-related pay packets for regulators and the increasing role that India and China can play in the global financial architecture. He also explains why the governments are forcing banks to cut their lending rats across the globe.
According to him, the phase of extreme crisis is over and a degree of confidence has slowly returned to the system but “we still got a lot to do to rebuild the financial system”.
Edited extracts from the interview:
The FSA is not the lender of the last resort. It does not have the moneybag to support the system in crisis. Shouldn’t it be dismantled?
Obviously in this sort of crisis the resolution requires an extensive action of the central bank and the government. That was clear in the UK bank recapitalisation scheme which had three elements – recapitalisation of banks with government money, government guarantees for the banks and the provision of liquidity from the central bank.
You’re absolutely right – in any sort of extreme banking crisis you need institutions which have monetary and fiscal resources to resolve it but that does not necessarily in any way invalidate the debate on whether the prudential regulations of banks should be done within the central bank or separately. Although we do the prudential regulations of banks with the FSA and not within the Bank of England, we cooperate very closely and carefully even in normal times. I don’t think it would have worked better if we have had prudential regulations combined with the central bank. Even if you divide these functions, there will be challenges that you’ll have to manage.
If you have prudential regulations inside the central bank you have to put in massive efforts to make sure that the prudential regulation is really independent and does not rely upon the fact that the central bank can always provide liquidity support.
What has occurred illustrates that if you end up with an extreme crisis you’ll have to resolve it with financial resources and only the central bank and the government have the financial resources and the regulatory authorities don’t. But I don’t think that in any case invalidate the FSA model.
So, there is no case for a revisit of the model?
I don’t think that’s necessary. Many different models can work but whatever model you have will have particular challenges of coordination and you’ll need to make sure that is correctly resolved. I am wary of the idea of rearranging the boxed or organisations every now and then.
Observers have been saying the days of “soft-touch” regulation are over and some tough measures ahead. Do you accept the fact that as a regulator FSA has failed?
Well, let me be clear that we have certainly never the used the word “soft touch”. We haven’t even used light touch. We used principle-based supervision and we can always go back and analyse the value of that approach.
The FSA had accepted, before I joined, that it had certain failures in the regulations of Northern Rock in particular. I think there were two categories of failures which were identified by our internal audit reports – one was a set of process failure in the supervision of Northern Rock and there was also a lack of adequate resources devoted to the supervision of Northern Rock. The second point is clearly there was a failure to look in a overall sense at what was happening in the whole financial system and the new forms of business models that were emerging and ask questions about their sustainability.
Three years ago we should have looked at the emergence of Bradford and Bingly, Northern Rock and indeed HBOS (Halifax Bank of Scotland), realising that they were all increasing lending at a dramatic pace and they were doing this by funding themselves in a new fashion through wholesale funding and sale of securities. And I think there was failure to ask the question -- is this whole model dangerous? We were doing supervision on an institution-by-institution basis but sometimes you can’t see the problem if you’re looking institution-by- institution. For that, you need to look at the total system.
These problems had been identified long before I took over as chairman and a superviosory programme is in place to address this with more people as supervisors, better training, better processes and also a very strong commitment to develop a better sectoral overview to look across the whole system and think through what the challenges are.
You have been talking about the enormous bonus packages that bankers get and the employees of institutions are better looked after than the shareholders. What does FSA plan to do on this?
Our key concern as a regulator is not the total level of remuneration. It’s really not for us to express a social attitude about total levels of remuneration. But our concern is the structure of how people are paid and whether people are paid bonuses for trading activities in particular which can produce risk-taking behaviour. Our concern is whether people are being paid large cash bonusses on the basis of the apparent profitability or trading activities before it is really obvious that the trading activity is profitabile and sensible in the long term.
Along with the Financial Stability Forum (an international body which looks at international regulatory issues) we are focussing on this. We are looking at practices in the UK market and we will be approaching it on an international basis. But we will not say that you can’t pay bankers more than X. We are likely to come up with a set of proposals to make sure that the way the people are paid is likely to reinforce the sensible management behaviour rather than unnecessary risk taking.
At the same time you have been saying how FSA employees should be paid better, market-related remuneration packages.
We are intending to increase the available rate of pay to key supervisors to make sure that we get quality people. You are never going to get regulators, a public body, paying a very salary which private sector pays. But at least the differential should not be too big. So, it’s not a matter of parity but at least you have to pay a level required to attract and keep people of quality.
As we deliver our supervisory enhancement programme, we are doing significant hiring from the external market and in some cases we have had to pay more than what are existing employees get. So we will have to adjust our pay structure so that overall there is a coherence system. Having said that, of course, it is the case that right at the moment it’s little bit easier to recruit from the financial services industry than it was last year. Although it is a generic problem that we have to get right for the long term I think over the next couple of years the pressure on our salary will probably get somewhat diminished.
Is this true of other developing markets such as India?
I think it is even more so an issue in developing countries. Because in developing countries the pay rates of people involved in international business are a very large multiple of the average income level of the country. You also tend to get a very tricky relationship between the top government officials and the top regulators. This is because the society feels that the top public servants should not be totally detached from the average salary of the populace... Of course, it is interesting that a lot of people believe that one of the best run and least corrupt emerging economy for many years was Singapore. Now it’s a developed economy but even when it was an emerging economy it was very explicit philosophy of Lee Kuan Yew Li that you’ll have to pay the top public servants sufficiently high to make sure that they will never ever be tempted by corruption and you’ll also attract the very high quality people.
It is a very difficult theme for developing countries because if you follow a high pay you will end paying public servants a huge multiples of average standard of living I recognise the problem. It’s a problem for us but I think it’s a much bigger problem for the developing countries where the disparity between the pay rates of international business and the average standard of living is much bigger.
Large-scale government support and the so-called nationalization of some of the world’s big banks to keep them floating has challenged the free market concept.
The financial base of free market capitalism is occasionally subject to excess overshoot and then collapse which requires rescue. The Japanese had to rescue their banking system in 1990s; the Swiss and the Fins had to this in early 1990s and the Amercians had to bail out their savings, loans institutions in the 1980s. These illustrate that the banks in particular are quite different from say car manufacturers or retailers … Because of the nature of financial markets, they may have a greater tendency to get carried away by irrational exuberance. And if they do, it has such bad consequences for the economy that you have to bail them out.
If a manufacturing company fails, it does not affect the whole system. That is why we have always recognised that financial institutions are different and they require regulations. There is no equivalent of the FSA for retailers. We don’t need to check how a retailer is managing the company in a safe fashion. We always accepted that financial institutions cannot be allowed to be in a completely free market economy. They are a part of regulated economy. We have realised that over the last few years the regulations did not work. It’s partly a failure to regulate certain institutions but even more so that some of our rules and systems on capital adequacy and liquidity at the UK level and even global level were not effective rules. It’s not that we have gone from pure laissez-faire to regulated capitalism because in financial markets we never had pure laissez-faire. We have realised that the particular form of regulation that we have had not been effective. We will have to get it right for the future.
You plan to regulate the system with iron hand. Won’t that jeopardise London’s position as the global financial centre?
I don’t necessarily believe that. After what has happened and the cost of the rescue to the public purse all we need to be worried about those issues rather than making sure that it does not happen in the future.
I am not concerned. Through out the world there is going to be a tightening of regulations. London is not alone in doing this and so I don’t think London will be disavantaged by having a more effective regulatory regime. London does have enormous strength as a financial centre. It will continue to play a very important role for wholesale financial services and one of the major centres in the world will be in European time zone because you can’t do all your businesses in say Hong Kong. There is a logic that there is a big financial centre in US and there is one in Europe and a number of centres in Asia and that will continue to be the case. Within Europe it is highly likely that it will continue to be London which is the dominant financial centre. I don’t think we are going to get more regulated than every body else. We will have more effective regulations through out the world.
There seems to be a paradigm shift in the global financial architecture and people have started visualizing a larger role for India and China.
You are absolutely correct. We need to find a way of bringing China and India into the long-term debate on regulatory structure for the world. It’s not a straightforward thing to do because when you widen the membership of a particular body you have a debate on who do you include. Why China and India and why not also Russia and Brazil? In a sense we do not make progress and it becomes too difficult to make decisions. Whenever you make a decision on who to bring within the fold, the next person gets offended. It’s not straightforward but I think it is obviously the case that we will have to widen different international bodies and include major economies such as India and China. Secondly, we already have and will increasingly have in future global scale financial institutions. Till today the major cross-national financial institutions have been the Japanese, European and American institutions. That is going to change with the increasing role of Chinese and Indian banks. We will have the find ways of widening the participation in the crucial consultation bodies for the world financial system.
The Indian financial system has a conservative regulator and it has been relatively less affected in the global turmoil. Does this justify the Reserve Bank of India’s reservation against opening up the sector?
I don’t know the precise details of what RBI has done. I think you’ll have to divide the different issues of conservatism and work out what really matters to you. Obviously, there is conservatism in relation to things like (capital account) convertibility and the use of derivatives, etc. and it may be that conservatism has indeed placed the Indian banks (in a safe zone). They simply have not been allowed and because they have not been allowed they have not ended up in some of the exotic and problematic areas of financial system.
But that’s an issue very different from opening up your local banking network to international competition. That’s a choice that India has to make but it’s not clear that more branches for international banks will make the Indian system less safe or more safe. It will probably be neutral and I think the issues there are different – on the one hand the desire to protect the existing Indian banks versus some of the benefits of competition.
But I don’t think these are prudential issues and whether you allow foreign banks to compete or open more branches actually has many prudential implications. The prudential implications come rather in relation to your liquidity rules. You have a set of liquidity rules such as very large reserves held by central bank and some people might have found them quite old-fashioned but we are all thinking now that the old-fashioned liquidity rules have some value. The liquidity rules, the convertibility issue and the rules of derivatives belong to the prudential side and we need to keep them separate from the issue of opening up and competition and branch opening, etc.
The Indian banking regulator is supposed to revisit the issue of opening up the banking sector in April 2009. Should it open up?
I think it’s probably not for me to recommend. On the whole, competition is a good thing but it is for India to decide (on) the precise pace ...
The UK government is forcing the banks to cut lending rates. We are seeing the same thing in India. Is it prudential for the system?
The answer is this is a not a system which can work in the long term but it may be an inevitable stage considering where we are. We have to realise that four weeks ago when we did the bank rescue plan we did in a sense tear off the existing rule book. These banks had adequate capital by the existing Basel II rule book – they were adquately capitalised banks as the banks in the US -- but we thought they would need more capital and if necessary that capital would have to come from the government. So the government becomes the shareholder and the shareholders have some rights. So, we made certain decisions which were deviations from the rule book but we had to do that because there was a crisis.
We are still in the crisis management stage. We are no longer in the danger of an absolute melt down of the world’s financial system but we are still in a very tricky, macro economic environment. The systen almost collapsed because of lack of confidence and that has left liquidity problems through out the system and banks’ failure to lend money to the real economy.
The government is still trying to work out what it should do in this environment and how far it wants to use its ownership stakes to achieve the macro economic objectives and how soon we can go back to as more hands-off rule-driven system. I am absolutely sure that after a period of time we want to get back to a system which is run on a set of clearly defined rules rather than ad hoc interventions. We will get back to a situation where the government follows a hands-off policy. What we are seeing today simply reflects the severity of what happened in the past few weeks Between the points where Lehman (Brothers Holdings Inc) failed and four weeks later where UK and other countries of the world intervened – the global banking system, the money markets were in danger. It was an extreme loss of confidence. It takes time to get back to normalcy...
So, what we are seeing today is an aberration.
I am sure we will not be doing these in two year’s time but it takes time to get back to the rule-driven system. It’s similar in the macro economy. We and other countries are going to run very large fiscal deficits and those deficits may well be appropriate to deal with the problem of deflation which we may face -- if not deflation, a very low inflation.
People are talking about quite radical forms of macro economic interventions such as fiscal expenditure financed by central bank’s money. That’s very extreme, not probably the stuff that Ben Bernanke has spoken in the past being the logical response to deflation, but it’s not what we have been doing for many decades. Rules might be broken but once we get past this crisis we want fiscal rules that prevent public borrowings. We want central banks not lending as much money as it is doing today to the banking system. We part-nationlised the banks and we got involved in debates with the banks on their lending policies. We have the central banks lending huge amount of money to the banking system. In the US, we have the central bank buying industrial commercial papers and we have governments borrowing and spending huge amount of money. Every single instance is way outside the rules that we wanted to stick to a year ago and the rules we want to stick to when we get back to normal time but we have been in an emergency situation .
Globally, inflation is no more a problem. The focus seems to be on growth. Right?
I think globally the problems of inflation are the least for the next few years. It’s hugely reduced. If we simply look at the spare capacity which will emerge in the major developed economies I think we will have almost no pressure... Look at the labour markets, the commodity prices, shipping rates, and oil prices. After the extraordinary spike that we saw in oil prices earlier this year there has been a very significant reversal . At least in the developed world we will see a dramatic fall in inflation.
Now, have the inflationary pressures gone away permanently? No, they haven’t.. But I think for the next two years, the inflationary pressures have dramatically reduced and the issue is actually more whether there is a danger of deflation.
By pumping in liquidity and capital, the central banks across the globe have adopted a sort of band-aid approach to the crisis and no body is actually going to the root of the problem.
The measures that have been taken were absolutely essential because when we get a downturn you have to take these measures. Let us be clear that the crisis could have led to severe global depression like what we had seen between 1929 and 1933. The reasons why it didn’t were the measures that we took. The fact is we know how to prevent the great recession. It’s by bailing out banks, spending public money and by providing liquidity through central banks. The great depression happened because of policy mistakes. We did not understand the enormity of the crisis; we did wrong things... Now we know what measures should be taken. I was always absolutely confident that the authorities would take the measures to avert a global depression.
You are right in the sense that now we need to find out what went wrong fundamentally. You will have to think about very specific things that we the regulators do: Did we manage the regulatory process well? Did we have the right people? Did we ask the right questions? Were there mistakes in rules on capital adequacy? Did we not have enough capital? Did we allow too many off-balance sheet items outside the capital regime? Did we not have the right approach to liquidity?
We need to get the rules right. What important is not how an individual supervisor enacts the rules but what the rules are. We also need to see whether the macroeconomic and monetary policies were allowing booming asset prices.
Should the monetary policy say that we will not only be looking at the consumer price index but if we see the housing prices rising phenomenally, we will deliberately pull back the economy?
You are absolutely right. We will have to deal with the crisis and must get the system right and make sure that it does not happen again in ten years’ time. We will have to think about it from individual supervision, international regulatory rules and monetary policy.
Can a supervisor make-bullet proof rules for risk management?
Individual institutions can manage some risks but not all. There were failures in risk management. But also there are some systemic risks where the risks are derived from the totality of behaviour of certain institutions and it’s very difficult for individual institutions to manage these risks.. They will have to be observed, analysed and managed by regulators and central banks. But the individual banks must know that those systemic risks are there and they must make themselves robust.
What lessons India can draw from the global credit crisis?
I think what has been illustrated is the enormous importance of getting financial regulations, capital adequacy and liquidity rules right. Therefore, it is a sign for a country like India as it grows and liberalises its economy that there are dangers in a financial system which have to be offset by very effective policies. We need to increasingly engage India and China in international debates on capital adequacy and liquidity regime.
Are we at the end of the tunnel?
We are through the phase of extreme crisis. We are not going to have major catastrophic defaults by major institutions. A degree of confidence has slowly returned to the system but it’s only slowly returning and we still got a lot to do to rebuild the financial system to enable it to play a meaningful role in macro economy.
The writer was in London at the invitation of the City of London Corporation.