The chief villains of the peace, at least if the vast literature on the subject is an indicator, were highly sophisticated financial products and the investment bankers who peddled them to clients all over the world. And now, in September 2009, itís all too easy to forget how most of the world made merry courtesy the very products and people we now vilify.
Consider, for example, the enormous benefits of the now maligned process of securitisation. This is the process of financial engineering in which a bunch of loans (house loans, auto loans, credit card loans) are bundled together and sold off to an interested investor. Securitisation took loans off the liability side of the balance sheets of banks and brought in funds from those who bought the securitised assets ó that enabled them to give even more loans, creating a virtuous cycle of liquidity. Combined with the diversification of risk that securitisation enabled, consumers and businesses were able to access finance cheaply ó cheaper than ever before. Itís no surprise then that while the party was on, no one was objecting, not even the subprime borrowers who subsequently lost their homes and savings. Even outside the US and UK, the benefits were enormous. Borrowers (particularly firms) from abroad were also able to access cheap finance and emerging economies like ours were flush with funds propelling growth to levels never seen before.
Needless to say, there were flaws in the system, which we now understand. But none are fatal enough to warrant fear of liberal finance, provided the right regulation is in place.
The basic flaw in securitisation arose from the fact that the bank which gave the loan to a consumer or business sold it off as an asset to someone else. Because the loan didnít stay on the balance sheet of the bank, they did not usually have sufficient incentive to check the quality of the loans they were sanctioning. Also, the investor who bought the bundled asset did not have the information to check on the quality of the loans in his asset.
The system would still have worked efficiently if credit rating agencies did their job, of carefully examining and appropriately rating the bundled assets, properly. But because they often had a conflict of interest ó they were paid by the same people whose assets they were rating ó they let too many suspect securitised assets pass with top (AAA) rating. When the history of this financial crisis is written, credit rating agencies will be the villains that got away. Somewhere, inexplicably, policymakers seem to have ignored the catalytic role that credit raters played in precipitating the crisis ó no one is even talking about regulating credit raters, forget about controlling their pay. So, securitisation can certainly work in the future if there is an appropriate intermediary (who can accurately and neutrally rate assets) between the originators of loans (banks) and those who buy securitised assets.
In India, though, a year after Lehman, we seem smug about and satisfied with our more rudimentary and unsophisticated financial system where regulation is very tight, securitisation and other complex derivatives are largely disallowed, and banks behave conservatively. Of course, the Indian financial system has been widely praised for its resilience in the crisis, but before we get carried away by the accolades it is important to note the costs of an unsophisticated financial system, which may outweigh the benefits of conservatism.
We can boast all we like about the resilience and profitability of our banks, but profitable banks are not an end in themselves. Banks can make profits by parking their money in safe government securities and relatively safe mutual funds, which is what they have in fact been doing in India since the crisis began. But if, motivated by excess conservatism, they refuse to channel money (savings) to productive sectors of the economy for investment, or to consumers for consumption, they fail in their most basic function, and do little to further the cause of faster GDP growth.
Of course, if we are content with 6 per cent growth then conservative banking is okay, but if we want 9 per cent growth then conservative banking of the kind we have isnít good enough, especially when one considers that the global environment isnít conducive to foreign capital flows. Even before the crisis, think of the kind of interest rate you paid on your home loan, auto loan, or the loan for your small business (or perhaps you never got one at all) and compare it with what the average American consumer or business paid (and always got), and youíll see the benefit of a more sophisticated financial system.
An under-developed financial system like ours extracts another price ó it blunts the effectiveness of monetary policy in a slowdown because of a weak transmission mechanism. The RBI has cut the two policy rates ó repo and reverse repo ó repeatedly and not insignificantly during the slowdown, but prime lending rates of commercial banks havenít nearly matched the depth of cuts made by the central bank. In fact, at many points in the slowdown, the double-digit prime lending rates were consistent with the higher repo rate from the boom time.
In more sophisticated systems, a cut in rates by the central bank almost immediately translates into a corresponding fall in the lending rates of commercial banks. Unfortunately, until determined policy action is not taken to liberalise and deepen the bond market, the derivatives market and the currency market, this transmission will, to the peril of our economy, continue to remain weak.
This why, one year after Lehman, even as the rest of the world discusses ways to regulate over-liberal finance, we in India still need to talk about liberalising over-regulated finance. And we can do it right learning the right lessons from this crisis.