Saved by chance, not design: Financial Express: 17th September 2009

Just as September 11 was a wake-up call for the battle against terrorism, September 15 has become symbolic of vaulting greed, something which may be likened to Macbeth’s vaulting ambition, which “overleaps itself, and falls on the other”. The newspapers are flooded with a retrospective on Lehman and its aftermath, all of which have been traced to the inherent ills in capitalism. Tellingly, even months after the rescue packages were announced, some bankers still have had the temerity to hike their bonuses and stock options, which is the ultimate arrogance of capitalist behaviour. Over here in India, RBI has marked the one year anniversary of Lehman with self-eulogies. The question to be posed is whether at all RBI actually expected the eventuality of the crisis. The answer is that no, no one did anywhere in the world. Otherwise 2008 would have been anticipated after 2007 when Bear Stearns and Northern Rock stumbled. The truth is that while we all knew that something was amiss, no one knew where the cracks lay. Now, when finance from banks is routed to any activity which is price-sensitive, and there is an upsurge in prices, commonsense would say that when prices fall there would be a problem. Therefore, overvalued markets always run this danger. But when is a market overvalued and when will the downturn happen? The answer is that no one can be certain. As Schumpeter had stated a long time ago, capitalism involves a continuous process of creative destruction and we get cleansed and learn as we got through these crises. Should RBI be applauded? To begin with we need to differentiate between the financial crisis and the liquidity crisis which resulted from the former. There was no financial crisis in India, as no institution had failed. Banks did not fail because none took the risks that were taken by their US counterparts. Besides, our system never dealt with sophisticated financial instruments and financial engineering remained confined to text books. In fact, it was quite ironical in the mid-1990s when the first capital market scam emerged, we didn’t know what the banker’s receipt was! Banking has, by and large, been conservative in its operations. Of course, this is a viable model which has been executed very well by RBI. The result has been the emergence of a strong system where risk is low but growth is normal. Innovation has been minimal. In fact, none of us really knew about securitisation and CDOs; and any such knowledge was restricted to textbooks or seminars conducted by professors from US universities. Therefore, to say that we did not encourage such operations is not convincing because we were not sure how they worked and preferred to keep away from the unknown.
Curiously, even today, the working of, say, the commodity futures market is an enigma and the differentiation between volumes traded and open interest created is not understood. Foreign exchange futures and IRFs have come in only in late 2008 and 2009! A banking system where over 30% of assets are locked in government securities and lending to another 40% is directed by the central banks cannot really face a crisis. The biggest potential default lies in the area of agriculture when monsoon fails but we always have governments coming up with bail-out programmes and hence failure is not possible. Further, banks have limited exposure to capital markets or other ‘sensitive’ sectors such as commodities and real estate. In India, we have never had bank failures, and when systems were challenged in mid and late 1990s with stock market related issues, it was more in the nature of fraud. The financial crisis in the West was not about fraud but clearly a case of financial engineering multiplying the possibilities of lending which was to be backed by spiralling prices. And when the prices crashed and defaults resulted, all those who were part of this onward lending spiral suffered losses. It did not have traces of crony capitalism of the East Asian variety. Indian banking has never really been on this line and has been confined to plain vanilla lending. In fact, the only aggressive and dynamic forays have been made by ICICI Bank and it is hence not surprising that our banks do not really feature in the global top league. RBI has done a great job in managing liquidity. However, there is little cheer in a parent feeling one-up on another because his/her children did not get hurt as they never went and played the game. The worry now is that financial reforms could take a back seat under these circumstances with caution being superseded by over caution.