By: Aditya Puri
Indian banks have unfortunately been in the news for the wrong reasons. While it is easy to scapegoat them, the current situation is actually the result of multiple factors. As a result of the financial crisis, the global financial system is under intense scrutiny. It is appropriate to examine the issues and possible policy directions for the Indian banking system while recognising our developmental imperatives and that we function in a globalised world. And while we learn from the financial crisis, we must also understand that crises recur at regular intervals. Over-enthusiasm to solve the problems that caused the last crisis may do more harm than good.
A brief examination of the cause of the crisis is in order. Over time, we moved from a highly regulated commercial bank-centred system to a complicated, highly engineered system. Much financial intermediation started taking place in markets beyond official oversight, and involved highly opaque engineered derivative instruments. The complexity, opaqueness and systemic risks embedded in these markets have still not been understood fully.
At the heart of the problem is the inherent risk involved in financial intermediation, whereby those who need funds get them through an intermediary or the market. The providers of funds insist on safe, highly liquid outlets for their money. Reconciling these requirements involves risks — credit, maturity and liquidity. Managing these risks was once the role of commercial banks, savings institutions and insurance companies, which were subject to regulation and had a safety net — the central bank. But in the new paradigm, intermediation is the domain of the open market. The general idea is that risk can be minimised by unpacking institutional relationships, separating maturity and credit risks, and creating instruments that would meet the needs of people willing to absorb these risks. The rationale was to encourage better pricing and distribution of risk. While this is efficient in theory, in practice it creates unimaginable complications.
The principal gatekeepers in the new paradigm were the rating agencies. But mathematical modelling and drawing inferences from the past to anticipate unexpected events are flawed. A combination of herd behaviour, opaque loan characteristics and the breakdown of market functions at times of crisis requires a reassessment of market participants and their functions.
Globally, regulators agree on the need for reducing leverage, better asset liability and systemic risk management, and oversight. However, a financial system should be a reflection of the continued…