109) DéjÀ vu in the financial sector

Financial crisis cycles, like business cycles, are endemic to our system. We see a boom and think it will never end. Sometimes, it really doesn’t when the state is waiting to bail us out.

Good shoppers know that you shouldn’t do grocery shopping when you are hungry, because you end up buying more than you need. Similarly, contractors will usually wait till it stops raining to fix that roof leak.

Henry Paulson, the US Treasury Secretary, however, did not heed such advice about the effect of timing on actions, and announced major reform of the regulatory framework for the financial sector even while institutions are in turmoil. We do not know i f all the problems have surfaced. Yet, the bank crisis arising from the disaster in mortgage loans that came from lending to unqualified borrowers appears to be the cause for this rush to regulate.
Of course, the advantage is that he gets to set the agenda of the debate that will follow. He may also successfully distract the elected representatives from their own knee-jerk responses to the situation. Reform in three key areas
The new framework that he has proposed is so broad that he clearly is not going to get it all done right away. Perhaps not even within the remaining months of the term of his boss, the President. Paulson wants to revise the existing structure and consolidate regulation in three major areas. One would be the Federal Reserve (i.e., the US central bank) which will oversee not only commercial banks but also securities firms, hedge funds, and commodity pools and will work towards securing the stability of the system.

The second would be to group the functions of separate regulators such as the Securities and Exchange Commission, federal banking regulators, and state regulators who oversee insurance industries and bring them all under one financial regulator. The third would be a business conduct regulator who will also take care of consumer protection.

Such a sweeping reform will upset several existing institutions and power bases. Already state regulators are beginning to complain as to why the federal government wants to usurp their powers when they feel they are doing a fine job and Paulson’s reply to that will be that some states failed to do their job of supervising the problem mortgage lenders. Smaller banks are dreading the increased scrutiny the new system will bring. Throwing up a key question

An important question that needs to be asked is whether the crisis in the financial sector is due to the absence of sufficient regulation and supervisory institutions, or whether the existing federal regulatory agencies did not do their job properly. For example, Citigroup’s balance sheet is in trouble and the Federal Reserve had enough authority to examine that on a regular basis and could have initiated action before the bank came to its present state. There is little need for more regulation if execution was the culprit. (Another example of weak federal regulatory oversight recently surfaced when several planes of Southwest Airlines had to be grounded because of safety issues, raising doubts as to whether the Federal Aviation Authority had been doing its job.)

It is only to be expected that the federal government must be seen to be acting in the present crisis. Citigroup and Merrill Lynch needed to be bailed out by inflow of investment from Sovereign Wealth Funds. UBS is struggling. And the Federal Reserve did not seem to think it wise to let market forces have its play in the case of Bear Stearns Cos, an investment bank, that was about to declare bankruptcy. Various officials used cataclysmic terms about the possible consequences to the financial system if that bank were to collapse, while justifying the action of the Federal Reserve, which stepped in and offered a loan to another investment bank, JP Morgan to acquire stock of Bear Stearns and bail it out. For the first time in over 30 years, the Federal Reserve was lending directly to investment banks.

Perhaps some institutions are too big and too important to fail. In 1998, the Federal Reserve orchestrated the rescue, of hedge fund LTCM, by private institutions, on similar grounds that it would be a disaster for the system.

Moral hazard issue

This raises the moral hazard issue, namely, that those who cause the problem do not seem to pay the price. The owners of Bear Stearns stock were bailed out with government help but bore some losses. But the management and board of directors of that company, who had ultimate responsibility for the decisions, seem to have gone free. I wonder if any of them are going to pay back their bonuses received the last few years when they took the decisions of selling highly questionable mortgage-backed securities. Old timers who believe in business cycles are not surprised by all the hullabaloo in the financial sector today. We saw the dotcom boom and bust. Then the housing sector went through it. The financial sector is going through a boom and bust cycle.

There seems to be a similar cycle to regulation too. The heightened scrutiny of the financial institutions that were instituted after the Depression of the 30s gave way to gradual de-regulation as various safeguards were diluted with growing confidence that the sector has matured and can be trusted to self-regulate. That is now giving way to greater regulation. Who will oversee the Fed?

We saw that one leg of the proposed reform by Paulson would restructure the Federal Reserve and give it increasing responsibility for oversight. But who will oversee the Fed?

Several experts have now voiced their opinions that a share of the blame for the current crisis must be placed at the door of the former Fed Chairman, Alan Greenspan, who kept interest rates low for too long, resulting in easy money that fed the housing boom. Whether he was doing that to keep the economy going, and therefore his political friends happy, is an issue that will need to be debated.

In today’s financial world, the problems of a giant economy such as the US quickly become the problems of the whole world. Major European banks, such as UBS, have also experienced the fallout from the US mortgage lending disaster. Municipalities in northern Norway are facing budget crises because their funds were invested in these questionable instruments. The financial services industry in the US has grown to be so dominant that it is said to account for about 20 per cent of US stock market capitalisation and about 40 per cent of corporate profits.

Thus, logically, if the world’s financial system is so closely intertwined, a country’s financial systems and structure must also have oversight from outside. But that will only remain a dream. For while the World Bank may have the courage to demand that developing countries restructure their economies as loan conditionalities, it does not have that leverage to scrutinise the policies and systems of its most powerful member.

Peep back into the past
If you think the current set of proposed reforms is going to fix the problems for the future, then think back to the Savings and Loans disaster in the US in the 80s and 90s. The taxpayers bore the costs estimated at $125 billion (Rs4,98,000 crore). Over 1,000 institutions collapsed and the primary cause of the problem was unsound real-estate lending. Does it sound familiar? That sector had been de-regulated earlier and of course, the fix after the disaster was more regulation, not that it helped prevent the current mortgage disaster.

Financial crisis cycles, like business cycles, are endemic to our system. How can it not be so, when mortals, subject to emotions such as greed, hope and ‘irrational exuberance’ are the decision makers? We see a boom and think it will never end. Sometimes, it really doesn’t when the state is waiting to bail us out.

C. Gopinath
(The author is a professor of international business and strategic management at Suffolk University, Boston, US. He can be reached at cgopinat@suffolk.edu)