Lessons from the financial meltdown

By far the most contentious debate triggered by the crisis has been about the flaws in the regulatory architecture. The thing to remember is that some regulations arguably have been behind the curve. There is no denying that regulations have to keep pace with innovations. In doing so, we must be mindful of the risks of tightening regulations so much that they stifle innovation. There is also the larger question of risk modelling. True, the probability of risk follows a normal distribution. But our regulatory regimes have been tailored to respond to the central, higher probability portion of the bell curve. Typically, we ignored the black swan lying in the long tail of the curve. We now know, with the benefit of hindsight, that this was a fatal flaw. The black swan represents the low probability, high-risk events that pose systemic risk. While our regulatory regimes were tailored to address institutional failures, they were not equipped to address systemic failures.

Across the world, regulations governing the banking system have been stringent on the premise that depositors’ interests need to be protected. However, under the very nose of the regulators grew an extensive network of a ‘shadow banking system’, comprising hedge funds, private equity and money market funds, broker dealers and structured investment vehicles. This highly leveraged system had an extensive nexus with the banking system. Yet, it suffered much lighter regulation, encouraging the hunt for quick yields and risky financial products. When the systems began to unravel, it was realised that many players in the shadow system posed as much of a systemic risk as banks. The moral of the story is that if an institution is ‘too big to be allowed to fail’, it is also too big to be let off with loose regulations.

Duvvuri Subbarao is Governor, RBI