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How the 2008 financial crisis changed banking

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Mint invited four professionalsZia Mody, senior partner of law firm AZB & Partners; S.S. Mundra, former deputy governor of the Reserve Bank of India; Arijit Basu, managing director of State Bank of India; and Sanjay Nayar, India CEO of private equity firm KKRto discuss how banking and financial services has changed over the past decade.

It all happened this week, 10 years ago. A lot has changed in the decade since the collapse of the storied Wall Street bank, Lehman Brothers. The past 10 years have changed everything: The nature of recessions, received economic wisdom, acceptable cultural markers, moderate politics of centre-left or centre-right. But how has banking, the core business responsible for the collapse, changed? Mint invited four professionals—Zia Mody, senior partner of law firm AZB & Partners; S.S. Mundra, former deputy governor of the Reserve Bank of India; Arijit Basu, managing director of State Bank of India; and Sanjay Nayar, India CEO of private equity firm KKR—to discuss how banking and financial services has changed over the past decade. Mint’s Rajrishi Singhal moderated the discussion.

Welcome to this roundtable. Why don’t we talk about what happened in the past 10 years. What are the lessons learnt? And, what does it tell us about the future? What does each of you think how the financial sector has changed in the past 10 years and, if possible, what are the regulatory structures that have accompanied these changes?

Nayar: A combination of things led to the financial crisis, but the biggest reason was huge over-leverage.

And, when there was an unwinding of risk, there was massive capitulation because of the huge leverage. Second, there were certain idiosyncrasies in regulation that were arbitraged. The fact is that two people were valuing risk in a different way: One part of the firm was putting on risk and the other part was shedding risk. Thirdly, banking system had a prima-donna culture.

What’s broadly changed in the past 10 years is technology playing a huge role, regulations have been tightened big-time, there has been a lot of separation of businesses that have conflict of interest; regulators and governments have seen what damage it can do and are therefore hugely hawkish. And I think we’re pretty balanced where we are.

Mundra: Firstly, the events 10 years ago have clearly established that self-regulation is a myth. Secondly, it clearly emerges that whenever the financial sector outpaces the real sector, such problems recur. As long as the financial sector is serving the real sector for real economic activities, things remain in control.

The day it becomes self-propelling, all kinds of problems start. The events a decade ago were a culmination of something that was already brewing. It will be wrong to believe that those events (Lehman Brothers collapse) were because of what happened three months ago or even six months before that.

US financial history shows that the Glass-Steagall Act was put in place under similar circumstances; and then when it was withdrawn in 1999, that was the beginning. Then gradually one thing led to another and it was famously mentioned in Fault Lines (by Raghuram Rajan) that at some point the political angle came in and then they said if you can’t provide employment, let them eat credit. Global regulation had a four-point agenda after the crisis: financial institutions should be made more resilient, too-big-to-fail should be done away with, make derivatives markets safer and the so-called shadow-banking should be converted into more market-based finance.

A lot of work is done, but a lot is still work-in-progress. Even for the international market, it is a mixed outcome. But for emerging markets, including India, these reforms had many unintended consequences: The banking sector has become very regulated, even perhaps over-regulated, whereas the same hasn’t happened to other sectors.

Mody: For me the journey, rather than the anniversary of the Lehman crisis, has been contradictory. Post Lehman, of course, regulators clamped down.

Today, as an intermediary, you proceed assuming that the regulator is not going to take your word at face value. You need to back it up with credible data.

In terms of over-leverage, 10 years later, are we less leveraged? The over-burdening of debt by businesses, maybe because of some slight euphoria after Lehman subsided and the recovery started, remains one of the biggest problems we face today. I also think, in some sense, we haven’t really moved. Crony capitalism is now termed as stigmatized capitalism; and how are we going to deal with that? The contradiction for me is that the system, from a deal-flow or an investment point of view, is on quite a bull run.

There is excitement, euphoria. The contradiction is: Do we have an economy as vibrant as we would like it to be? And do we really see a vibrant private sector putting money into the ground? How are these two going to converge? And if the financial sector doesn’t keep up with the real sector, we’re going to have the same problems again. This contradiction is a worry.

Do we have a bull run? If so, how do we sustain it? It is a global economy, where a lot is interconnected—you’ve got Trump, our elections. So, interesting times.

Basu: Lehman is just a date. If we step back a little, the subprime crisis was there in the US from 2006. But the impact has been tremendous across the globe.

Unemployment had started hurting; 20-25% unemployment in Europe and other parts is still par for the course.

Inequality has widened, which is why you see far-right and far-left everywhere. Because of the low interest rates, which came in due to quantitative easing, the mark-to-market pressure on pension funds has put their viability in question.

Insurance companies are reworking their models, which is not the case in India because we are still in the growth phase. In India, a lot of ground has been covered. Trade and protectionism has multiplied, which is worrying.

USA was one clear leader in 2008, which brought the world together; but now it seems to say I don’t need to be the leader any longer and I will do what is best for my country. And even if you look at debt, it was 110% of the total GDP then, it is at 170% today. In total terms, I believe it has increased by $70 trillion to $237 trillion.

The balance sheets of the central banks of developed countries have taken on $15 trillion. If something new were to happen today, the easing which was possible in 2008 would not be possible.

But then we have covered a lot of important ground. Liquidity is an important consideration for all banks; banks globally have become more universal. And emerging economies such as India and China are growing.

Crisis can again happen at any time, but I don’t think it will happen in the same manner or for the reasons that was behind the crisis in 2008.

From where do you see the next crisis emerging? What are the pressure points? Can our huge consumer lending be one?

Nayar: I don’t think we’re going to have a crisis because we do one thing right. We have a big fiscal deficit, but we borrow locally, in rupees, so it crowds all of us out. We are not a disaster waiting to happen, because we don’t borrow in dollars, which is what happened in Argentina, Brazil, Mexico and other markets. Our crisis must be redefined: Getting stuck in this band of 6-7% growth. That’s our crisis. We won’t grow at a higher rate unless there are some serious reforms. And let’s focus on only one reform—banking reforms. We have talked about it for so long, there have been so many committees, it’s time to implement the ideas. We should be regrouping the public sector banks. This can be done. Given that we have large fiscal deficit, bond markets are not going to boom overnight, and insurance companies will not start capital lending overnight. So even if the animal spirits come back, where is the money going to come from? India has a real capital issue, which is when you borrow using foreign capital. Between private equity and venture capital, 90% is foreign capital. And then you have FII (foreign institutional investor) money coming in. A small tweak from Sebi generates so much noise today, which tells you how dependent we have become on foreign savings. The more you bring in imported savings—either debt or equity—then the fact that we didn’t borrow for fiscal deficit in dollars, gets nullified. Ultimately that money has to go back.

Mundra: There is another proposal in global regulations—that risk weight should also be assigned to sovereign borrowing. This is because many EU countries have borrowed in dollars and have defaulted. But if you apply the same principle, banks’ entire SLR (statutory liquidity ratio) portfolio, which is currently carrying a nil rate, will have to carry some weight—even if it is 1-2%, it will stress the already stressed capital condition and affect the banks’ ability. External linkages will always be a potential problem that may arise. Within the banking system, while retail looks like a new mantra for everyone and panacea for all ills, what is slightly worrying is whether people doing the underwriting have the right capabilities. Banks need capabilities on three sides: Identification of borrower, processing of loan application and collecting ability. Another very important point is that retail has become the game of selling at the point of origin. There are nimble and younger players who can go to the point of origin and cater to customers. There is another segment that is equally enamoured with retail, but does it from the comforts of its cabin. There is a possibility that they are getting the leftovers or the rejected, and that can create a problem.

Mody: I don’t think we will have a large Lehman type crisis, but I think the crisis is—India growing at 6-7%. We don’t need to do anything for it to grow at that rate, it’s just India will keep growing at that rate. How do you really enhance that? How do you create responsible capitalism, responsible banking? I go back to the question of the ecosystem that has to be created. You need to energize bankers so that they can accept the proper risk. But it seems, every banker is concerned about how this is happening on my watch, and why should I take any blame. If you look at the situation commercial banks are in, they are forced to become development banks. You didn’t give them 20-30-year money, but forced them to lend development funding on a short-term basis. I think the crisis is for everybody, and everyone should share the blame and go back to the real economy.

Basu: All calculations say that we should multiply five times by 2028, we should have a $5-7 trillion economy and I don’t see why it can’t happen with a one-billion-plus population. But we are facing structural issues, which need to be addressed. While we are not staring at a crisis (because the potential which is inherent in the economy is so vast), we cannot say that global issues like trade don’t affect us. The banking sector is also impacted globally, but not to a large extent. The regulator needs to find the right balance. To be fair, the regulator appears to be more conservative than in the past, and that is because the economy is in a situation that it has never confronted before. We cannot blindly borrow norms from the West. On the other hand, the capital ratios have traditionally been higher than what it was overseas. Our credit-deposit ratio has been much lower at 70-75%, whereas other economies of our size have 110-125% ratio. And this makes India much safer. Even the kind of risks that regulators have to address in India are different. Some of it might be more intense than other countries, some of it can be much more relaxed. Financial institutions will remain, As will the public sector, given the state of the country and the inequalities. But this digital thing will be a major differentiator. In terms of risk mitigation, there are endless possibilities that are available. When CIBIL makes a presentation to us, the kind of data they have and which can be used to mitigate corporate risk, is huge. But banks will have to find a balance—it cannot all be retail lending.

Mundra: But that brings a larger risk issue, which is an entirely different debate—the way roles are now commingling. Insurers are lending, asset managers are lending, banks are doing distribution. The question that should be debated now is: Should regulations be entity-based or activity-based?

Former RBI governor Raghuram Rajan said that one of the outcomes of the global quantitative easing was a surge of liquidity in the system, which led to misallocation of capital, mis-pricing of assets and distorted investment decisions. Do you see distorted investments?

Nayar: In India, I don’t think so. Of course, the markets are a little overvalued, and somebody might say undervalued, but I don’t think there is any distorted lending happening. There isn’t that much of capital around. The US has real capital and real deals.

Basu: If you want to do project finance in India, there are certain structural issues, which lead to problems. So, one has to be selective. In roads, the centre has come up with new models, but even in these we see weaknesses, such as the hybrid annuity model. We need employment, which can only come from SMEs. We do whatever government-directed lending we are mandated to do. But there are companies which are not mandated to do so. These are between 10-100 crore entities and employ 50-100 people. Here, banks are not taking the kind of risk they should be taking, perhaps because of the systemic problems. The ecosystem has to improve. The banks have to look at risk a lot closer than what they did five years ago.

Mundra: One thing is clear: A few things coincided. Fiscal stimulus at the time, introduction of public-private partnership model, infra becoming a new sector, all these things conspired to happen at the same time. Bankers have learnt a strong lesson. Lending on faith, belief and assumption has always been a part of banking. But they have realized today you can’t do any lending based on any of these. And then, it is important to bring in the policy environment, because it is not only careless bankers or rogue borrowers, but a larger play which has brought us to this situation. With the bankruptcy code, the borrowing community is far more disciplined and the banking industry is more informed. If all get their act together, it will be good for the economy. Globally, the so-called shadow banking and derivative markets are very different; asset managers can leverage, use derivatives. There are many problems in that segment and regulations are yet to reach them like they have for banks. In India, this segment is not facing the problem; they are strictly regulated. In India, what is worrying are the strong interlinkages between banks, asset management companies and finance firms. What concerns me more are global banking regulations designed for international banks with cross-border operations. Each country is at a different stage of political and economic progress and applying the same law to everyone is not an ideal solution. It could even be counterproductive for an emerging market like India. There is room within global regulations to apply national discretion and seek long time periods for implementing a new regulation. Take capital, for example. The kind of risk weight you give to different assets, or the kind of treatment you give to collaterals, differ from one country to another. If you normalize every-thing, it is quite possible that you may find Indian banks quite overcapitalized compared to its counterparts. There is a need to have a relook at international regulatory norms.

Disruptions seem to be the new normal. After 2008, we had the taper tantrum, Silent Spring, Grexit, Brexit, the Portugal, Italy, Greece, Spain (PIGS ) crisis, the Chinese devaluation, and then Kim Jong Un. Every time there’s a bit of a kerfuffle the markets tank, and the ripple effects spread far and wide. What kind of regulatory structures will help stabilize something like this?

Basu: A lot of regulations have come in, both globally and in India. There are two broad aspects. If you want financial institutions to be resilient, you need both capital resilience and liquidity. So, liquidity coverage ratios, BIS guidelines and Basel-III guidelines have kicked in across the globe and they are valid for us. India, in any case, was a little more prudent than other countries. Even globally, we will not see a liquidity problem, if some crisis emerges today. Capital ratios are 3-7 times the leverage that’s being taken. But just a warning: In the 1929 crisis, the capital ratios were fairly good and it did not help. So, by itself, capital and liquidity will not help. But in the Indian context, right after the crisis, we managed it well. From 2007-10 we did not see Indian banks face any issue. But there are many peculiarities in the Indian economy and its banking system. For example, because of the absence of term lending institutions in the system, commercial banks had to take up the slack. Thereafter, because of how the economy has played out since then, a lot of it has turned sour. Not just banks, but the economy has also been affected. The regulator has taken steps to ensure that stress is revealed. We are at the end of the cycle, where, whether banks want it or not, the stress is out. How it will play out from now, will depend on banks’ financing, and how the economy grows. But the impact is different in every country. Argentina is in a huge crisis again, today, even though everybody thought they were past it after their 1999 crisis. Turkey was supposed to be in a growth phase, but see where it is today. In spite of all the regulations, you can have surprises anywhere in the world, and we need to guard against that.

Mody: Given what has been said about banks having the necessary ratios, etc., we see very little lending on the ground. Put that down to fear factor, paralysis factor, risk factor. And this has adversely affected the SMEs, who are in a sense the engine of the economy. You could have reasonably healthy balance sheets after the clean-up is done, but I am not sure that lending will continue. While we claim the macros will look good, there are so many external issues that affect us—our balance of payments, the oil prices, the sliding rupee. I’m not sure prudent regulation is always a good thing. How is it dripping down into letting the economy kick-start? I see very little enthusiasm in banking.

Mundra: The most prominent risk in the global economy over the past few years is event risk, not market risk or credit risk or operational risk. I don’t think there is any mechanism, which can insulate nations from event risks. My suspicion is they will keep happening with regular frequency. And, as past governors have famously mentioned, it is impossible to control a crisis. What is important is when the bubble bursts, how fast do you clean up. Let’s first understand what’s going on at the global level. Post crisis, global trade has grown at 2%, whereas world GDP has grown at 3%. It means trade finance growth is lagging behind GDP, which never happened earlier. It has always outpaced GDP growth. We have gone back to basics, regional protectionism is already happening. Hence, investment activity at the firm-level has dampened. More interestingly, if you look at total international capital flows, there is no reduction in FDI at the global level; it has slightly increased. Also, there is no reduction in investment in the stock and bond markets. Only thing that has reduced is the international flow of bank capital and bank lending. So, only banks have been strictly regulated, while other sectors remain as they were. Since banks are no more in their business, these events will happen, we cannot wish them away. Compared to 2013, we are better prepared now, our forex reserves are much higher. But you can’t remain insulated from global developments, nor can you prevent them. You have to prepare to deal with them as they happen.

Nayar: Banks overseas are very well governed and restructured, the real economies have picked up in the West. One risk developing is that in the search for higher yields, a lot of alternative lenders and high-yield funds have given very cheap and high-risk credit for acquisitions. That is one bubble. However, the Western economies have many checks and balances and the market is a true corrector. Closer home, we don’t need more regulations. Today, banks under prompt corrective action (PCA) are unable to give 5 crore more to a well-meaning company, growing at 10-15% organically. They don’t even give you a no-objection certificate for a pari passu charge to a non-PCA bank, or a functioning NBFC that can give extra credit. We escaped the 2008 crisis with a massive consumption stimulus. We all know what happened after that. We built overcapacity and over-leverage, and unwinding is happening. We really need to capitalize on the next 3-4 years, but for three decades we haven’t done any real economic reform. I think IBC is perhaps the most significant one. Real economic reforms are those which will de-bottleneck India’s supply side. When demand picks up, inflation picks up, rates go up. We need the private sector to come back with a fairly high degree of confidence, and banks and capital markets to play their role. Though we’ve been saying capital markets are robust, we’re not actually creating new assets. We’re just refinancing. Real asset creation has got to be the main agenda. Then we are the least vulnerable because we’ve got a massive domestic economy and, thanks to our regulators, we do nothing in an extreme way. So, although we are less vulnerable, we’ll become vulnerable if we depend on every marginal dollar to support our stock market or rupee. We should use our local savings pool, go into long duration, and real assets.

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