My friend Prakash wrote to me on 25th 0ctober 08 from the USA that conditions in the US are very very bad. No assurance of market, job and wages. Its greater than depression. Govt does not know how to handle the situation. For the last 20 years, US borrowed and spent money as if there was no tomorrow. Now they are bankrupt. Its a life time depression for our generation. Indian economy will suffer much more. The Banking sector in US has lost confidence. Even the Banks among themselves don't believe each other. Indian economy will sufer much more. Our (Indian) size of economy is very small and survival will be difficult. Prakash ended his commentary about the US economy with his philosophical touch, "...any way days will pass on."
The disastrous happenings in the USA have impacted the world economy with a cascading effect. Though I have been reading about the bad shape of the US economy, nothing has been in such plain and simple but razor sharp words coming from an onlooker at the site of the financial Tsunami. It was shocking and also somewhat amusing to read about this sorry state of the Big Brother. However, I did not agree with his views about the Indian economy and immediately responded, "As regards the financial turmoil, you are right - it is an unprecedented recession born out of all sorts of excesses through out the world. But it is not going to be long drawn like the Great Depression of 1930's particularly because now there is a high level of communication and co-operation among the governments to deal with the situation. Though there is no material change in the fundamentals, the confidence is shaken due to exposure of the big names in the global financial markets. So the first priority is to restore the public confidence in the financial institutions. This can be done by the governments with a pragmatic approach. In India the situation is not that bad because the financial system is so far insulated. Of course, the problem of liquidity will be there in the system due to flight of FII funds from the markets. But then, it can be sorted out with the government support and right approach."
This analysis of the situation was based on my close acquaintance during the four-year assignment in investment banking at London during the start of boom years. Having been brought up in my banking career at an ultra-conservative public sector Indian bank, it was a revealing experience for me to watch the exotic and daredevil working of the global banking giants. There were frequent occasions at the official Cocktail Receptions as also casual evening meetings in the bars/restaurants to discuss about the day's working and, more importantly, businesswise what's new happening in different banks and financial institutions. During these informal chats, instinctively I would try to convince my counterparts about the virtues of conservative appproach in a risky profession like banking and finance. But often my advocacy of conservatism would meet with a rebuff about the Hindu rate of gowth.
Now when the financial Tsunami has struck both sides of Atlantic, my belief in the efficacy of financial conservatism is fully justified when recently I read a report on IBN Live News dated 08 December 2008 titled 'Morgan Stanley slams RBI for easing norms' as reported by Dinesh Narayanan/Forbes-Network18. The report highlighted that the RBI's prudential norms are far stricter than what many developed countries apply to their banks. Its caution was vindicated recently when Indian banks remained reasonably insulated from toxic assets that brought down hallowed financial institutions in advanced markets.
This report was in the context of the Reserve Bank of India's announcement on the 6th December 2008 allowing banks to restructure real estate loans on softer terms and relaxed norms for recognition of bad loans owed by other borrowers. It is interesting to note that the analysts at Morgan Stanley were not happy in their report about relaxations in the prudential norms by the Reserve Bank of India.
However, the big confirmation about the conservatism of Indian financial system comes from the New York Times reporter Joe Nocera. Recently Joe came to Mumbai hoping to learn about the current state of Indian business in the wake of both the credit crisis and the terrorist attacks of 26 November 2008. To his surprise, he found that the banking regulator in India was just opposite of Alan Greenspan. He candidly admits, "India had a bank regulator who was the anti-Greenspan. His name was Dr. V.Y. Reddy, and he was the governor of the Reserve Bank of India. Seventy percent of the banking system in India is nationalized, so a strong regulator is critical, since any banking scandal amounts to a national political scandal as well. And in the irascible Mr. Reddy, who took office in 2003 and stepped down this past September, it had exactly the right man in the right job at the right time.
“He basically believed that if bankers were given the opportunity to sin, they would sin,” said one banker who asked not to be named because, well, there’s not much percentage in getting on the wrong side of the Reserve Bank of India. For all the bankers’ talk about their higher lending standards, the truth is that Mr. Reddy made them even more stringent during the bubble.
Unlike Alan Greenspan who didn’t believe it was his job to even point out bubbles, much less try to deflate them, Mr. Reddy saw his job as making sure Indian banks did not get too caught up in the bubble mentality. About two years ago, he started sensing that real estate, in particular, had entered bubble territory. One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans. (Guess who wound up financing the land purchases? United States private equity and hedge funds, of course!)"
"Then, as securitizations and derivatives gained increasing prominence in the world’s financial system, the Reserve Bank of India sharply curtailed their use in the country. When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding onto the loans they made to customers. On the one hand, this meant they made fewer loans than their American counterparts because they couldn’t sell off the loans to Wall Street in securitizations. On the other hand, it meant they still had the incentive — as American banks did not — to see those loans paid back."
"Seeing inflation on the horizon, Mr. Reddy pushed interest rates up to more than 20 percent, which of course dampened the housing frenzy. He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made. In effect, Mr. Reddy was creating liquidity even before there was a global liquidity crisis."
“He basically believed that if bankers were given the opportunity to sin, they would sin,” said one banker who asked not to be named because, well, there’s not much percentage in getting on the wrong side of the Reserve Bank of India. For all the bankers’ talk about their higher lending standards, the truth is that Mr. Reddy made them even more stringent during the bubble.
Unlike Alan Greenspan who didn’t believe it was his job to even point out bubbles, much less try to deflate them, Mr. Reddy saw his job as making sure Indian banks did not get too caught up in the bubble mentality. About two years ago, he started sensing that real estate, in particular, had entered bubble territory. One of the first moves he made was to ban the use of bank loans for the purchase of raw land, which was skyrocketing. Only when the developer was about to commence building could the bank get involved — and then only to make construction loans. (Guess who wound up financing the land purchases? United States private equity and hedge funds, of course!)"
"Then, as securitizations and derivatives gained increasing prominence in the world’s financial system, the Reserve Bank of India sharply curtailed their use in the country. When Mr. Reddy saw American banks setting up off-balance-sheet vehicles to hide debt, he essentially banned them in India. As a result, banks in India wound up holding onto the loans they made to customers. On the one hand, this meant they made fewer loans than their American counterparts because they couldn’t sell off the loans to Wall Street in securitizations. On the other hand, it meant they still had the incentive — as American banks did not — to see those loans paid back."
"Seeing inflation on the horizon, Mr. Reddy pushed interest rates up to more than 20 percent, which of course dampened the housing frenzy. He increased risk weightings on commercial buildings and shopping mall construction, doubling the amount of capital banks were required to hold in reserve in case things went awry. He made banks put aside extra capital for every loan they made. In effect, Mr. Reddy was creating liquidity even before there was a global liquidity crisis."
In the boom periods conservatism is considered as an anachronism. The virtues of conservative approach look good only in the agenda for discussions at conferences and seminars. Aggressive marketing becomes the norm in the financial markets. The well-known credit weaknesses are interpreted as normal market practices when the goal is ever increasing slice of market share for the bank/financial institution. When the going is good we often hear experts telling us that regulations restrict entrepreneurial spirit and make the managements risk averse. The historical perspective of the twentieth century clearly indicates that the clasical route of business cycles passes through conservatism - good times - exuberance - complacency - laxity - weakening of checks and balances - bubbles - financial Tsunami - chaos. Then in the falling markets and sluggish economy, we realise the virtues of conservatism. Finally we return to conservatism and embark on a new cycle. These milestones on the route of business cycles are best illustrated by the Glass-Stegall Act which was passed in 1933 and repealed in the new millennium. Having repealed it, we are now again taking regulatory steps to have something like Glass-Stegall Act in place to separate ownership of investment, insurance and banking functions!
Brick by brick we build protective walls around us out of necessity. Protective walls bring prosperity, which in turn leads to complacency and gradually we tend to get rid of protective walls for entering into risky ventures. So long as the going is good, we want the governments to keep their hands off our risk appetite. When we are hit badly in our risky ventures, we instinctively seek regulatory support and protection from crisis! The synthetic generation of our financial products is now at a turning point, where conservatism and prudence will again be highlighted and dynamism (aggressiveness) will take a back seat in the financial decisions. QED!
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