Last week’s Group of Twenty (G-20) summit in Washington has led to calls, mainly from European leaders, for a radical re-engineering of the free-market system. The suggestions for change have included new taxes on capital flows, protectionist trade restrictions, sweeping changes to accounting rules, and greater political control over some institutions. The US, however, seems to have taken the view that any effort to regulate financial services will stifle the innovation on which the market rests.
The right view lies somewhere in between. We don’t really need governments to intervene with arcane currency arrangements, Tobin taxes and protectionist rhetoric. We do, however, need greater regulation within financial markets. If at all there is a political response to an economic problem, it should really be by way of more useful regulation in certain markets. India, as an example of balance between the free market and mature banking regulation, should actually lead the way out of this crisis.
Proponents of the case for greater control over markets and capital flows have pointed a finger at the iniquity of a system where Americans steeped in debt can now deprive Indians (and others) of a chance to join the growth party, and can, through their actions, cause borrowers in India to pay higher interest rates, small companies to default and individuals to see their savings eroded by capital flight. Although, when put this way, there can seem to be merit in the case for structural change, we need to enquire whether an attempt to curb the peaks and troughs that are the natural corollary of free trade and capital flows cost more than the benefits that these have brought to nations over the last 20 years.
Should those who benefited from the flow, now seek to distance themselves from the ebb? In the Indian context, people and companies included in the capital market system have benefited the most since the 1991 reforms. The high level of borrowing here was supported by interest rates well below the long-term cost of capital and was driven by capital inflows of the past decade. It is not at all clear that the millions in India who have benefited from the upside of globalization and free capital flows really have a strong case for changing a system that has worked so well for many.
Having defended the status quo for free capital flows and minimal change in the markets, we believe the US preference for light-touch controls betrays a continued faith in the self-regulatory nature of markets, despite recent evidence to the contrary. It would be worthwhile to revisit John Maynard Keynes, whose understanding of the psychology of markets remains unrivalled and who in 1936, wrote “...the situation is dangerous when the enterprise of a nation is supported by the whirlpool of speculation...” Keynes was a votary of stronger levels of regulation, but just enough to keep alive the animal spirits of the marketplace. This nuanced approach, of changing only the least savoury aspects of the marketplace, is what we need to follow now.
Even the most ardent believers in deregulated markets agree that these unsavoury practices include a tolerance of leverage ratios of 30 to 1, opaque trading in securities to a level of hundreds of times the values of underlying assets, and the misuse of low margin levels by speculators. Consequently, much of the response across the G-20, just needs to address a significant reduction in leverage ratios worldwide, a consequent increase in the capital adequacy level that financial institutions require to maintain and the creation of exchanges for exotic instruments, where these are absent. Most importantly, governments need to subject all market players to similar levels of transparency.
Finally, even the best of national regulators have their limitations in a complex world. Boards of financial institutions and banks are the first and strongest line of defence against risky behaviour. Surely, regulation can be brought in to place greater duties on the asset-liability committee and the risk committees of the board. There is no reason why a more detailed and public certification with regard to asset liability mismatches, off-balance sheet exposures and risk could not be submitted to the regulator.
Most recent crises were predominantly limited to emerging economies and used to be attributed to economic mismanagement in those countries. Such conclusions are less readily drawn now. There is an understanding that global capital movement is a difficult servant to master, and actions in one market can have consequences around the world. To rephrase John Donne, “Now no nation is an island, entire of itself and any market fall diminishes us all, and when the exchange bell tolls, you know it tolls for thee.” This recognition in itself is perhaps half the answer to future crises. If, in addition to recognizing this, the G-20 can also agree to revert to a common framework for transparency, regulation and leverage they will perhaps have fixed much of what caused the current financial tsunami.
Govind Sankaranarayanan is CFO, Tata Capital Ltd. He writes on issues related to governance. The views expressed in this column are personal.
Write to him at firstname.lastname@example.org