Soon after its dawn, the 21st century experienced too many market upheavals in quick succession. Collapse of the IT bubble marred 2001. The following year witnessed massive defaults by large broadcasting and telecom companies in the US.
In 2005, consumer bankruptcies (over 2 million) shook the US financial markets, but in 2008 the sub-prime mortgage fiasco shattered market confidence globally. According to the IMF, losses from the sub-prime mortgages could touch US $1 trillion, a fifth thereof hitting banks and the remainder the investment companies and insurers. The truth, however, is that banks would book bigger losses since (as indirectly indicated by Munich Re and Sun Alliance) insurers of many bonds that banks hold could collapse forcing banks to foot the losses of the bond insurers.
The most worrying part is a significant loss of investor confidence in market players' capacity for risk assessment, advisory, and management. Investors now take long to pick up even triple A-rated (a rating that has lost its gloss) fresh debt paper, and trading in secondary markets is on the decline because banks are no longer as interested in providing liquidity to these markets. The leveraged investor has virtually disappeared.
Although central banks injected cheap liquidity (some grudgingly because of a natural resistance to accept supervision failure) into the markets to avoid the collapse of their financial systems, banks did not pass all of this benefit on. Cost of funds for everyone, including banks, has not fallen despite cuts in base rates because banks remain uncertain about the future, which may impair the process of credit creation if this perception continues.
Instead of blaming aggressive lending for what happened, bankers now doubt LIBOR's validity as a yardstick even for interbank lending. Revising the basis for fixing the LIBOR can't make up for a tendency to accept risks without ascertaining borrowers' sustained capacity for repayment. The solution lies in improving focus and commitment to good lending, not fiddling with the LIBOR by including therein a risk factor; determining this factor was and should continue to reflect each bank's own view of borrower risk.
Banks lost out not because of LIBOR but because of their flawed desire to sustain earnings by charging floating interest rates without ascertaining the limits to their borrowers' capacity to absorb large and quick increases in loan rates. It reflected a dangerous tendency for depending on financial illiteracy of common borrower as the mainstay for sustaining bank profitability.
While according to J.P. Morgan's head of debt capital markets, trends in secondary debt markets reflect "substantive disconnects" between different markets across regions and asset classes, the truth is that they all reflect investor frustration with gross weaknesses in credit quality and incompetence of the sources that provide assurances about credit exposures being safe and trade-able in secondary markets.
The most worrying aspect of this scenario is that low investor confidence is dampening investment and economic growth. Mohammed El-Erian, CEO of Pimco (fixed income management outfit of Allianz) believes that "during the next few months we may witness a new phase of dislocations, led this time by the real economy" and predicts a move for greater and broader regulation of financial activity.
Will regulation further restrict growth or will it re-build investor confidence? The way things are, regulation could only re-build shattered investor confidence because there is no room for defending de-regulation that reposed excessive confidence in professionalism, social responsibility, and integrity of the market players. Bankers alone are responsible for tarnishing their image that will now prompt re-regulation.
According to Mervyn King, Governor, Bank of England (BoE) "it is imperative for the Central Bank to be directly involved with an institution much earlier that it might need to support later on". How "direct" could this involvement be is unclear. But the fact that Mervyn King has been re-appointed Governor BoE for another 5-year term (in spite of criticism of his reacting slowly to the sub-prime crisis) shows that re-regulation is very much on the cards.
Regulation must now emphasise to bankers (as done by BoE) that liquidity injection doesn't imply tacit central bank acceptance of whatever happened in the markets as the usual cyclical affair. It would be wrong for bankers to push the markets back to where they were a year ago, hoping that borrowers' financial illiteracy would still allow banks to pocket unfair returns (but, more likely, losses resulting from pricing loans on floating rates without a cap or ceiling).
While banks need re-regulation, Central Banks too need to review de-regulation that permitted out-sourcing, especially loan marketing. Secondly, if banks are to repose confidence in credit rating agencies in spite of all that happened, who will regulate these agencies to prevent their going overboard? From now on, what should a risk rating indicate: current risk profile (as claimed by these agencies), or a view of the future risk profile, as believed by most who relied on these ratings?
Some credit rating agencies helped create clever looking Mortgage Backed Securities (MBSs) based on poor investigation or self-serving assumptions. There would be no future for securities if their ratings were based on insufficient investigation of the underlying assets and borrowers' repayment capacity. Credit rating agencies must be required to disclose these aspects in detail to push them into doing a truly responsible job of risk rating.
In Pakistan, we permitted PBA to certify asset valuation agencies. The recent zero-rating of forced sale value of non-cash collateral of borrowers-in-default indicates a slide in SBP's confidence in these agencies. If that is so, what is the alternative envisaged by the SBP? Banks' first quarter 2008 results show the impact of inserting such an overcautious safety lock without tax relief on the losses resulting from zero-rating of collateral.
Regulations permit banks to lend against inventories of raw material and finished goods, but we have yet to regulate warehousing in the private sector. It is amazing that in spite of this infrastructure gap, we have created a Commodity Exchange. Given this gap, will the instruments (warehouse receipts) traded on this exchange be truly as good as cash? Don't we need a properly regulated nation-wide warehousing network?
Finally, banks should realise that they are paying the price for designing compensation packages - a number game that sidelined quality, responsibility and institutional loyalty. The greed and grandeur associated with financial gains undermined bankers' quest for becoming hardcore professionals, more so because rewards were paid well before the consequences of lending had materialised.
Mervyn King intends to formulate regulation whereby BoE will "contribute to the design of regulatory and incentive structures ....to curb the excessive build-up of risk-taking and credit creation" that led to the recent crisis. It is time other Central Banks too looked into this vital issue to eliminate the long-term harm to banker psyche caused by such packages, and consequent impact thereof on prudence in risk management.
Reviving investor confidence is imperative for sustaining growth in developing countries that face huge risks posed by unprecedented escalation in commodity prices and are also victims of internal political instability. Re-regulation that revives investor confidence by assuring greater responsibility on the part of market players could sustain economic growth (even though at a lower level) in such difficult times.