In a double whammy of sorts, the stock markets had to grapple with the sudden resignation of Urjit Patel as Reserve Bank of India (RBI) governor and a defeat of the ruling Bharatiya Janata Party (BJP) in key state elections.

The markets, for some strange reason, not only shrugged these events off, but celebrated them.

The exuberance was most visible in stocks of banks and non-banking financial companies, many of which have risen over 10% in the past three trading sessions.

As was pointed out earlier this week, the markets are heaving a sigh of relief at Urjit Patel’s resignation, given the central bank’s tough stance on matters such as regulation of banks under him.

Shaktikanta Das’s appointment as RBI governor is being cheered, as he is seen as more approachable and responsive to the demands of companies and markets. Stocks of public sector banks, whose lending activities have been reined in by RBI, are also making merry on the expectation that these restrictions will be lifted.

This is the typical lopsided, short-term thinking stock market traders are well-known for. Easy regulations result in quick profits; if it means that some institutions may go bust as a result in the long run, traders will typically leave those worries for later. In any case, trading behaviour is largely guided by narratives that are trending on the Street.

As one forex trader had famously put it to the Wall Street Journal years ago: “Ninety per cent of what we do is based on perception. It doesn’t matter if that perception is right or wrong, or real. It only matters that other people in the market believe it. This business turns on decisions made in seconds. If you wait a minute to reflect on things, you’re lost."

For now, the perception of the Street is that banks and other institutions that struggled to grow under a tight regulatory regime will flourish under easier regulations.

It’s another matter that, not too long ago, most of us were ruing the fact that regulatory forbearance was also to blame for their poor financial state. In fact, the clean-up in the banking system was rightly being lauded as one of the key policy achievements in recent years.

To now fall for the argument that “regulatory forbearance is the need of the hour", is silly. “The markets’ enthusiasm over certain bank and financial stocks goes beyond short-termism. It is retrograde. Instead of appreciating that a clean-up of the system results in long-term gains, the market is excited about the prospect of an easing of regulations for firms that managed their managed their balance sheets poorly, " says Venkatesh Panchapagesan, associate professor of finance at Indian Institute of Management-Bangalore.

“If, as the market hopes, regulations are eased for poorly run financial institutions, it creates a moral hazard. Rather than push institutions to operate more efficiently, this will send the message that lobbying for easier regulations is a more lucrative course to follow."

Evidently, the markets have no patience for these arguments at present. As the economist John Maynard Keynes said, stock market traders are like beauty-contest judges who vote on the basis of expected popularity with other judges, and not on the basis of absolute beauty.

It’s fair to ask the question: “Why worry about short-term excesses of the stock market; why not leave it to its own devices?"

By all means, except when there is the likelihood of using market reactions to legitimise questionable policy measures. Lobby groups have already been pushing for an ease on the regulatory front with regards to banks and financial institutions. In this backdrop, it’s tempting to see the recent reaction of the stock markets as a proxy for a popular vote, and RBI as an unnecessary hurdle against a policy that everyone agrees is good for the economy.

But let’s not get carried away by the messages the markets give, as a former chairman of the Securities Commission, Malaysia, had warned. “We have become rather overawed by financial markets; not without reason, just look at their size and sophistication. But let’s not confuse form and substance. Rather like the late Arthur Ashe once said of the then young and brash John McEnroe, the market can be immature beyond its years," Dr Mohd Munir Abdul Majid said about twenty years ago.

Not much has changed since.

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