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ShareGovt control of markets is best avoided
Lighting a match is an individual prerogative and is of no concern to the local fire department. However, lighting a match in a room sprayed with petrol is very much a matter of public concern, for it is suicidal and poses a danger to the neighbourhood.
By analogy, complex financial products, securitisation and innovation, etc are matches, whereas having large leverage is like 'spraying petrol'.
The impact of leverage, though elementary, is illustrated in the table for the benefit of the finance industry, which in its greed seems to have lost its bearings. Even for a safe investment such as the 10-year US Treasury Note, a wide range of returns is possible -- 4% at zero leverage to 104% return at 100:1 leverage.
Opportunistically ignored is the fact that leverage produces exactly the opposite effect when there is a loss.
Since T Note carries zero credit risk, it is used as collateral to borrow at cheap rates in the money market. Hence the leverage.
As the collateral is marked-to-market, asset prices and leveraging get intertwined, thus unleashing pro-cyclicality in both directions.
In developed markets, be it personal finance or the investment management industry, operating with large leverage is the norm.
Long Term Capital Management (LTCM) of the US, which imploded in 1998, had leverage in excess of 100:1. Incidentally, the stock market scams of 1990s and 2000s in India were also flamed by excessive leverage, albeit illegal.
Therefore, from a public policy perspective, regulation of the level of leverage is imperative to prevent a systemic crisis.
Yet, what has been the systemic progress in de-leveraging? Very little, going by available evidence.
Banking capital adequacy norms under Basel II, using sophisticated models for rating risk, provide for decreased capital, hitherto not available under the Basel I norms.
In 2004, the US SEC decreased the capital requirement for broking subsidiaries of large investment banks. Consequently or otherwise, recent leverage ratios of Deutsche Bank, Bear Stearns and Morgan Stanley were 50:1, 33:1 and 30:1, respectively.
If leverage is indeed the problem, then prevention of crisis would entail capitalisation.
Capital requirement under Basel I was 8% of risk weighed assets - a bank was required to have a net worth of $8 for every $100 lent to/ invested in corporates (as risk weight assigned to corporate credit risk was 100%, irrespective of rating).
The Basel I framework, though simple, makes no separate risk weightage for leverage, i.e. bank capital remains constant, irrespective of the level of leverage of the borrower.
To remove this anomaly, it is proposed that additional risk weight be assigned for leverage in direct proportion to the leverage of the borrower.
To illustrate: Consider a corporate with net worth of $200, borrowing $100 each from banks X and Y (leverage ratio 1:1). At 8% capital adequacy, the two banks need to have net worth of $8 each (weightage for credit risk is 100% and for leverage risk is 1) The combined capital adequacy of banks X and Y would be 8% when the borrower's leverage is 1:1.
When the same corporate borrows an additional $200 from say bank Y (leverage ratio 2:1), it is proposed that the capital requirement for bank X would be $16 ($100 X 100% X 2 ) and that of bank Y would be $48 ($300 X 100% X 2) as the weightage for leverage risk will be 2. The combined capital adequacy of banks X and Y would be 16% when the borrower's leverage is 2:1 (combined net worth of 64 on combined assets of $400).
The proposed capital adequacy norms would also apply to embedded leverage (common in most structured products), off balance sheet exposures such as guarantees.
At the macro level, the proposed norm will effectively break/ severely impair the transmission link from monetary excess to build-up of asset bubbles. However, with due respect to black swans, in the eventuality of a bubble burst, banks will be more than sufficiently capitalised, thus preempting public bailouts.
The foremost advantage of the proposed framework is that it is 'simple' - no reliance on sophisticated models. It is holistic - assets and liabilities of both borrower and lenders are factored in assigning risk weightage.
The proposed norm will not stifle innovation or private risk taking. Leveraged positions in complex securitised products, compounded by credit default swaps on collateralised debt obligations, magnified the credit problem in the US housing market into the present financial crisis. Even bereft of leverage, complex products can continue to be innovated and traded, based on genuine economic value added and not on the intermediary's commission. However, without leverage, their ability to cause systemic disruption will be severely curtailed.
The present crisis has raised the clamour for larger intervention by the state in private commercial activity. However, the experience of Indian economy from Independence till the 1991 crisis, points to the contrary. Extensive micromanagement by the state degenerates into a dirigisme of 'license-quota-permit raj', sustained by strong vested interest (Read Glimpses of Indian Economic Policy by I G Patel). Therefore, controlling the markets is best avoided.
Simple and holistic regulation is the way forward.
Our limited interaction with participants in the conference on "Restructuring beyond the subprime crisis" at the Asian Development Bank, Manila (September 18-19, 2008) gives us the feeling (prejudice?) that some of the perpetuators are unrepentant. Perhaps, the czars of capitalism are no different from the commorades when it comes to defending vested interest.
The validity of the proposed framework can perhaps be gauged by the contempt and derision elicited from the vested interest.
Above all, at a macro level, the root cause of the problem, namely, loose monetary policy, needs to be addressed in a concerted manner.
The writer works for the Securities and Exchange Board of India and can be reached at manjeshhere@yahoo.co.in. Views expressed are personal and do not in any way reflect the views of the Board.
