Europe debt is bigger worry than slow US recovery

Europe debt is bigger worry than slow US recovery

Mumbai: The aftermath of the financial crash of 2008 has witnessed a profusion of academic research trying to explain the why’s and how’s of what went wrong. What makes Viral Acharya stand out in the crowd is not just his insightful analysis of the perverse incentives in the banking system, but in his enunciation of practical policy alternatives.

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Acharya, a professor of finance at the Stern Business School, New York University, has recently co-authored a book on the Dodd-Frank Act, which has put in place a new set of rules for banks in the US. Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance is probably the first independent assessment of the regulatory changes in the western financial system today.

Acharya spoke exclusively to Mint on regulatory reforms and the policy challenges India faces, on the sidelines of the Emerging Markets Finance conference organized by the Indira Gandhi Institute of Development Research (IGIDR) in Mumbai. Edited excerpts:

The attempts at regulating Wall Street seem to have fallen short of most people’s expectation save, perhaps, the bankers. What is the main reason—successful lobbying by banks, or the lack of a well-thought out plan by the Obama administration?

First of all, the Dodd-Frank Act, despite its limitations, does make some progress. The existing regulations had failed to take into account the systemic risk that a financial institution might pose to macro-economic stability. The fact that the Dodd-Frank Act puts that as the primary consideration while designing regulation is a very important step.

But I would agree that the Act falls in the trap of doing things the way we did in the past, by tweaking the existing structure rather than accepting that we need a fundamental rethink on what we are doing.

Some of it is based, probably, on the fact that there is resistance from industry to every single thing, and regulators need the help of industry to co-ordinate on some of these issues as it is expensive to design a fool-proof set of rules.

Secondly, the Act is concerned, to a large part, with banks rather than important markets that the banks are engaging in. It overlooks the exposure of banks to repurchase and sale agreements—the repo market or the money market funds. Those links still exist and leaves the door open for the next crisis in case a large financial institution was to fail.

One feature of the post-crisis economy has been a growing recognition by businesses of the need to forge deeper ties with governments which were the drivers of economic growth. Do you think big government is here to stay with more regulatory powers, and what does this mean for a country like India which seemed to have just come out of a license-permit raj?

I think this is a crucial issue and I would like to highlight two things. It is very clear that when you have a large-scale failure of financial systems and collapse of investments and trade, you need an injection to revive the patient. Secondly, if you look back at history you would find that many times, the seeds of crisis were sown because governments lacked the grace to exit. The key is to design interventions where you have time-bound exits. In the case of India or China, which are set to have strong growth, I think this is an opportunity to unleash the forces of private enterprise.

This is not to say that markets need to be de-regulated, rather one should allow free access to capital wherever possible without compromising financial stability. While the state-run banking system in India is seen as a source of strength, I would argue that we should strive to move to an era where we do not need to provide stable banking of this magnitude which involve a lot of inefficiencies.

Do you think the recent problem with real estate loans of state-owned banks is an instance of the kind of inefficiency you were referring to? And what kind of banking overhaul do you have in mind?

My research shows that in the post-crisis phase, public sector banks in India had access to easy money.

Since their access to government guarantees was perceived to be stronger, there was a flight of deposits from private sector banks to public sector banks. When you get such easy money, it generally leads to inefficiencies and excesses in investments.

German Landesbanken, Spanish Cajas and Fannie Mae and Freddie Mac in the United States are other examples where access to state guarantees created a perverse business model of risk-taking.

I would argue for a regulatory system that makes banks pay in proportion to the systemic risk they pose—so different banks could have different charges or capital requirements. And there are various ways to measure systemic risk —a crude but simple way is to look at the beta of the banking stock to see its correlation with the rest of the market.

It is also worth considering whether Indian financial sector still needs the presence of state-owned banks, or is it time for a graceful exit.

Do you like the idea of a super-regulator like the Financial Stability and Development Council in India? How will it affect the credibility of regulatory actions by the Reserve Bank of India (RBI), say?

I am in favour of a council kind of approach. Invariably, as financial markets develop, you have financial entities performing different roles in different markets and you could have regulatory slippages when you deal with a large entity, which can be taken care of by a council.

Besides, it is important for regulators governing different markets to coordinate their actions and I think the council allows that.

Which do you think is a bigger worry—the slow recovery in the US or the risk of a contagion spreading in the sovereign debt markets of Europe?

The lack of demand in the US continues to be an issue, but I think the bigger macro-economic risk is in Europe where there is still no clarity on how they are going to deal with debt problems.

The stronger economies like France and Germany are taking a case-by-case approach, and one reason for that I think is that banks in those economies are not as well-capitalized as those in the US or UK. They could be badly hit if there is sovereign default in more economies because of their exposure to sovereign bonds.

So, I think the way ahead would be to recapitalize those banks and go for some sort of fiscal union or joint liability model for Eurozone members that gives the market a sense of confidence which the bank stress tests failed to provide.