Lessons from past crises

History has an eerie way of repeating itself and memory of the pain of busts, according to economist John Kenneth Galbraith, is perhaps the best regulator. Hence, we owe it to the system to recollect and recount lessons from past crises. The key lessons are how to anticipate and take pre-emptive action and, once you are in the middle of it, how to respond effectively viz. crisis management. During my journey in the RBI, I’ve witnessed crisis situations of differing dimensions and feel veteran enough to share these and draw lessons from them.

The Balance of Payments Crisis
In 1991, our forex reserves were down to 11 days’ worth of imports. While the crisis was triggered by an increase in oil prices and the Gulf war, the underlying factors were the macro imbalance in the form of unmanageable current account and fiscal deficits.

• Exchange rates should not be overvalued for long periods. Also, entry barriers should be removed or reduced to facilitate competition.
• Liberalising equity flows first is a better option, followed by commercial credit and longer term debt, while limiting the financial sector’s access to foreign debt.
• Financial sector repression—excessive interest controls and credit rationing—is deleterious to growth. (But) the sector requires prudential regulation and effective supervision.
• Excessively high remuneration on reserve requirements erodes monetary control.

The Securities Irregularities of 1992
The irregularities reflected speculative buying in the stock market funded by bank liquidity through repurchase transactions in government securities and bonds. The events that led to these irregularities could be attributed to weaknesses and lack of transparency in the market infrastructure for government securities (G-secs), excessive liquidity with public sector undertakings, nexus between banks and brokers, and inadequate internal controls that led to bank funds flowing to stock markets, fuelling an abnormal stock price rise.

• Need was felt to institute a delivery versus payment mechanism for trade settlement in G-secs. A central counterparty, Clearing Corporation of India, was later established, which undertakes guaranteed settlement for G-secs and forex market trades.
• Administered interest rates should be removed. Only the savings bank deposit rate is fixed.
• There is need for real-time dissemination of information on individual transactions in G-secs.

The NBFC Imbroglio
The non-banking financial companies (NBFCs) have been subjected to a relatively lower degree of regulation vis-à-vis banks. Also, features like no entry barriers, no requirement for large investment in fixed assets and inventories, etc, led to their unbridled proliferation. A few such companies, which were perceived to be functioning well and, hence, had a large depositor base, defaulted in repayment. This highlighted that the extant framework was inadequate in regulating NBFCs.

• The crisis led to the recognition of the possibility of regulatory arbitrage between the entities regulated by banks and NBFCs as well as between the securities regulator and the bank regulator.
• Need for legal powers to regulate the activities of NBFCs, including framing of guidelines for compulsory registration, stringency in conditions for deposit-taking companies that were akin to banks, and the applicability of prudential norms for such companies.

Asian Crisis of 1997: The First Global Contagion
The Southeast Asian crisis, which started with stock market and currency crashes and spilt over to the realty sector, changed the way Asian countries looked at issues of financial stability. The Indian market was not immune. The impact on the domestic interest rates and liquidity was the cost to be paid for restoring stability.

• Need was felt for complementarity between macroeconomic stability and financial stability. Besides, we learnt that exchange rate management was crucial for preserving confidence in the economy.
• During asset price booms, it is important to ensure that banks’ exposure to capital markets and real estate is not excessive. Also to understand that banks can be subject to forex risk even without any currency mismatches, when their constituents have huge unhedged exposures.
• Management of capital account is important for countries having chronic deficit and where inflation and interest rates are persistently more than the global levels.

Urban Cooperative Banks: The Weak Link
The tightening of regulation in the banking and NBFC sectors saw the gravitation of risk to the lightly regulated Urban Cooperative Banks (UCBs), which were under dual regulation of the RBI and the registrar of cooperative societies. The stock market crash in 2002 triggered a payments problem and a large UCB, Madhavpura Mercantile Cooperative Bank, crashed due to its huge exposure to one broker. The systemic implication was that as hundreds of small UCBs had an exposure to this bank, their collapse, though confined to a small region, would have been very disruptive. In any case, the Madhavpura Bank collapse led to an erosion in public confidence and there were a series of UCB failures.

• Need to reduce interconnectedness within the financial system as it leads to the moral hazard of being ‘too interconnected to fail’.
• The most lightly regulated entity in the financial system becomes the weakest link. This link becomes a source of reputation risk and leads to erosion in public confidence.
• Despite being under dual regulation, the bank regulator has to take steps to resolve weak banks.
• In dealing with a crisis due to interconnectedness, breathing time needs to be provided through a liquidity injection.

Failure of Global Trust Bank in 2004
A very large capital market exposure and shortfall in provisioning were the causes for the downfall of the bank. The common depositor does not have the wherewithal to study bank balance sheets before making a deposit, but even institutional investors seem to be gullible. It was also realised that though insolvent, a bank can carry on without a run as long as it has adequate liquidity or access to liquidity. This experience gave us valuable lessons on how to deal with a bank run.

• The resolution process should be swift and decisive, preferably over a weekend.
• In a computerised system with 24/7 banking, the preparation for a moratorium has to be much more meticulous than in traditional banking. Also, adequate liquidity and currency must be kept ready to stem a run once the resolution strategy is decided.

As for the current crisis, the major learning is that globalisation has meant no country is immune to the happenings in global financial markets. The presence of interconnected financial entities across several jurisdictions with regulators at the national level has posed huge challenges in ensuring that there is no regulatory arbitrage and that there is coordination among regulators. Even within a jurisdiction, it is recognised that all regulators have to deal with systemic risk and there is need for inter-regulatory dialogue and vigilance.

The lecture, a part of the Institute of Banking and Finance Distinguished Speaker Series, was held in Singapore on 12 October 2009.