Dealing with financial distress

Dealing with financial distress

In a speech in Washington, on 17 October, Reserve Bank of India governor Y.V. Reddy once again drew attention to the “prevailing heightened uncertainties in global financial as well as monetary conditions". Back home the same day, the stock market fell dramatically, fearing that the surge of foreign inflows would be stopped by the Securities and Exchange Board of India (Sebi) controls. The finance minister had to “calm" the market down.

Risk is fundamental to investment, but all the money sloshing around the world has made risk assessment very fuzzy. Anything that can be measured and priced is traded in the market and an array of instruments now allows greater diversification of risk.

Global financial institutions have boosted linkages across borders as more countries have opened up their economies. With many new players such as hedge funds and private equity firms, the increase in complexity has made the whole system extremely unpredictable, difficult to find where risks originate and how they will spread. More competition to get higher returns, coupled with the possibility of taking on more risk, has meant a build-up of investment positions that can be unsustainable. Assets are held with the anticipation that they will be traded and any whiff of disruption in this expectation can upset investors’ equations.

As Claudio Borio points out in a recent paper at the Bank of International Settlements, the new financial system is “funding liquidity hungry". Even when funds are not scarce, there can be concerns about the creditworthiness of the other participants; a withdrawal of money when it is needed the most leads to financialdistress.

Also, households are bearing much more risk than in the past. This increased exposure to the markets is through mortgages, through pension plans that are more self-financed than paid for by the government or firms, and through direct investments in financial markets. Not a severe problem for India yet, where bank deposits dominate the financial portfolio, but definitely the picture of the future.

Financial instability, as Borio puts it well, is “not like a meteorite strike from outer space; it is more like the result of the sudden release of the pressures that build up owing to the shifts in the tectonic plates of the planet". It is the responsibility of the regulators to ensure that the financial system framework works towards reducing the damage. Of course, risks vary across countries and across time.

In a 2004 United Nations Conference on Trade and Development paper, Ilene Grabel of the University of Denver advocated a trip wire speed bump approach to help manage financial distress better. This approach does not rely on the market to self-correct when a crisis is impending. Rather, it calls upon regulators to set up trip wires that will act as vulnerability indicators—when these are triggered, regulatory changes or speed bumps are to moderate investor behaviour and avert a crisis. For example, sudden flight of foreign portfolio investment can lead to a sharp fall in asset prices and lower creditworthiness of domestic firms. A trip wire here could be the ratio of total accumulated foreign portfolio investment to gross equity market capitalization or gross domestic capital formation. When the ratio rises to disturbing levels, the regulator can either work on slowing the inflow or put in outflow limits; the precise limits and consequent action would be country specific. This is similar to circuit breakers in the stock market that work to strengthen the market rather than put off players.

Sebi’s proposal to moderate inflows through participatory notes is an example of regulatory change to address the risk of high portfolio investment, but the approach has been quite heavy- handed. Let’s face it, India needs the foreign money; at the same time, there should be more transparency, from participants and from regulators. A policy framework worked out in tandem with all regulators and the finance ministry should provide stability by improving clarity and building trust in the system, when the rationale behind the timing of a regulatory decision is better understood by the markets.

According to Borio, who also makes an analogy with roads, so far, policy emphasis has been on improving the state of roads, for instance the payment and settlement system, which raises the level of transparency and ease of making transactions, thereby increasing efficiency. Efforts have also been made to put in place buffers to prevent excessive damage from accidents—for instance ensuring minimum capital standards, more effective regulation of banks and other financial institutions, etc. What are needed now, he says, are speed limits that limit excessive risk taking by parties.

It is unfortunate that both researchers have taken metaphors from roads because, given the condition of roads here, one wonders what to make of them in the context of India. Trust we shall trundle along like the traffic on GT Road, sometimes on the left, sometimes on the right, mostly in the middle. There is hope ahead, of course, despite the muddle, but the speed of change leaves much to be desired.

Sumita Kale is chief economist of Indicus Analytics, a Delhi-based research firm. Comment at