New Delhi: Vinod Thomas is director general, Independent Evaluation Group, or IEG, an independent group within the World Bank. As its head, he is entrusted with the task of evaluating the bank’s work. Currently on a personal visit to India, Thomas spoke to Mint about the regulatory implications of the subprime crisis and the economic challenges that confront the country. Edited excerpts:
Bankers in India, at times, trace the subprime crisis to regulatory gaps. When there are regulatory gaps it is easy for different regulators to lose sight of the interconnectedness. How would you look at it?
The regulatory oversight is essential, especially when there are financial innovations which have a positive side of smoothening financial intermediation, but have inherent risks attached to it. Those risks at the micro level are related to the nature of leveraging, excessive leveraging and off balance sheet activity which are not adequately accounted for and you need regulation to cover them.
What happened in the recent years is that innovations far outstripped the capability and scope of the regulatory framework, particularly the subprime lending and the related asset bubble, which the regulatory framework was not, even in design, able to capture. (There was) a lot of reliance on self-regulation which did not materialize.
Analytical view: Vinod Thomas feels that innovations far outstripped the capability and scope of the regulatory framework, particularly subprime lending and the related asset bubble in recent years. Harikrishna Katragadda / Mint
Let me hasten to add all this was compounded by a pro-cyclical nature of macroeconomic imbalances that were also being created. The combination of the two—at the micro level lack of regulatory framework and at the macro level of massive imbalances—translated into a gross understatement of the risk and therefore a huge bubble that was created which was just waiting to burst.
One debate we have seen here in the recent past stems from the comparison between the way the former Reserve Bank of India (RBI) governor Y.V. Reddy dealt with what he thought was a bubble forming in real estate as early as two years ago, as compared with what Alan Greenspan did early on where the approach seemed it was very difficult to judge if there was a bubble or not. How do you see this debate shaping up?
I think the excessive valuation in the market of assets is the underlying reality. The excessive exuberance is partly driven by the fact the growth rate remained fairly robust across the board, the lack of regulation and also the ideology that underscored this whole phenomenon—that regulatory frameworks are not necessary ...the eventual collapse of it, then swinging the pendulum back to the positive role of regulatory framework, is the outcome of this very tough situation.
The exact beginning of the bubble is obviously a question mark, but obviously two years ago the writing on the wall was clear, but since growth rates continued to be solid that just put off the reckoning plus the ideology that underlined the whole approach that regulatory framework were almost a bad word created a situation that until the crisis actually hit, the series of actions that were necessary were postponed. If the actions were taken a couple years ago both the financial and human toll would have been that much less.
In the context of regulation, it is very likely we are going to see the introduction of some kind of credit derivatives in India next year. Recently, RBI governor D. Subbarao in a speech identified financial stability implications of credit derivatives as a challenge for a regulator. Could your share your thoughts on it?
The systemic risk that emerged in the US context can be related to a number of factors, among which the financial innovations, including the use of derivatives and the excessive leveraging that took place, required greater reliance on regulatory frame, but in reality (it) was the face of an outdated regulatory system that couldn’t even understand the nature of the instruments, derivatives for example, or very opaque nature of new players or configuration of new players that came in. So the result was rather than having more regulation the effectiveness of existing regulation was that much less, transparency had fallen and disclosure practices were very poor.
As these instruments improve intermediation and improve credit markets’ choices and diversity, equally, responsibility on the regulatory side is that much greater.
In the wake of bailout packages in the US and UK, acknowledging the unique situation the financial sector finds itself in, do recent actions throw moral hazard out of the window?
First of all it is quite remarkable. Basic business 101 would have told such degree of mismatch, such degree of leveraging and such poor use of regulatory framework would be associated with serious risk, that in the end turned out to be the fact.
Looking back, why were they not detected in time, gives you a number of factors that played into the way things turned out. When faced with it again business 101 would tell you there is serious moral hazard in bailing culprits out, especially if the bailout, by nature of the market, they favour the rich and not the poor, provide the basic moral hazard that you will continue to take those sort of risk because you will get bailed out again. The basic economics of business would argue against providing such bailouts and certain types of bailouts we have seen. There is the other overriding factor, which also you hear from basic business 101, that you have some situations where all bets are off.
The crisis is so severe the importance of bringing back some order, liquidity and confidence into the system is so overriding a concern that the bailout is far more important than the moral hazard, which needs to be confronted as time goes on and provide other actions to ensure it is not interpreted as a permanent solution when these sort of things happen.
Have you been closely following the measure taken by the authorities in India to deal with the situation?
I have been following the global (measures), including India. The point I would make is here is a crisis that clearly originated in the US and spread to OECD (Organisation for Economic Co-operation and Development) member countries.
China, India, Brazil and Russia have been growing at very robust growth rates and a good part of the growth is clearly linked to the high degree of globalization and trade they were able to enjoy in face of high growth in the OECD member countries as well. Now, with the turnaround just as they gained, they have been hit even as the macroeconomic management in these countries, the developing countries, have been fairly robust.
So the key question is what instruments would India have to employ? Here, those countries that have current account or fiscal surpluses clearly would draw on that strength to have fiscal packages that are large enough to offset the demand from external sources. China would clearly be a case in point on that.
In the case of the world as a whole, something like 2% of the GDP (gross domestic product) is what would be needed as fiscal stimulus. India’s latest plan seemed to be headed that way. But despite the fiscal tightness India has, the extent of decline in the global demand...2009 and 2010 would require sizeable domestic demand stimulation. One part is the reduction in interest rate balanced by the concern for inflation.
Quickly, you are on to the need for fiscal stimulus...just increasing the fiscal spending is only a part of the answer, the quality of that spending is what is critical. Here, this would be an opportunity to turn it into a positive, to put the financing into critical areas where returns can be quick and strong.