Sunday, January 20, 2008

Should Central Banks Be Generous?

These posts have spoken earlier about the Sub Prime Crisis and how bearish Central Bank made sure we remained insulated from the Crisis. ( how far the De Coupling theory stays true is anyone's guess however!). the Sub Prime Crisis is a Black Swan event and like all Black Swan events, it has brought winds of change in public policy in general and banking regulation in particular. it is time that we reflect on these winds of change and so this post I revisit a related issue;
Should Central Banks act pro-actively to save banks and other Financial instiutions from goin down under? Are there good reasons to intervene and inject liquidity in a failing bank? The answer to the first question till last year would have been a straight No, but after the battering systems received last year, the present system seems to be leaning towards interventionism.

So should we have a system where the Bank Of England or the Reserve Bank intervene and inject liquidity, the moment it sees a bank is in the red? or should we have a system where decisions are taken by Central banks on a case to case basis, intervening only when it foresees that failure of banks has systemic effects. It is interesting to note that the Central Banks Of England and United States till very recently followed a " systemic effect" intervention policy in keeping with the laissez faire nature of the economy in those states while bank regulation in our Country has been based on a multi factor test, inter alia including Depositor interest and public interest and stability of banking system.( These factors cannot be simulataneously balanced; indeed some are antithetical to each other. for example, a particular bank might not be systemically important and so it might not be in public interest to bail it out; however acting in public interest here is directly prejudicial to depositor interest as they stand to fail if the bank is not protected).
the recent Crisis has however as i earlier pointed out brought out interventionist thought in laissez faire thinking.( See how Mervyn King did a volte face and decided to bail out Northern Rock; his early speeches were an eulogy to " systemic effect intervention").

My understanding however is that this change in policy does not augur too well for the Economy. the Economics of bail out suggests that the tax payer pays for share holder apathy. and a sustained policy therefore subsidises risk taking by unscrouplous bank Boards and incentivises further apathy by the share holders. In the long run , market discipline suffers and no one is happier. Rather all Central Banks should return to the " systemic intervention" plank and restrict their altruism to that factor alone. that way owners will monitor banks effectively, agents will have less incentives to self deal substantially reducing agency costs.

It is not my case that the intervention policy is wrong; it is however emphatically my case that it must only be followed this one time; till the crisis is over.

Darwin was not a evil man was he?

Sunday, January 6, 2008

Should Banks be Held Liable For Excesses Of Recovery Agents?

These posts have hitherto been talkin about the macroeconomic policies that India ought to follow. So, this post I take a break and talk about a problematic issue in microeconomic area.the problem of recovery agents and the excesses they commit in the course of recovery of loans from retail borrowers has been in news of late. Recently, the National Consumer Commission delivered a verdict that held a reputed private bank responsible for the excesses committed by its recovery agents. the Bank was held responsible for "deficiency in service". the media generally welcomed the judgment and the general consensus was that it was a welcome step that struck a blow for consumer movement in the Country.

this post I look at whether banks should be so held responsible for the excesses committed by its recovery agents. Of Course, if we take a " law as principle" approach inspired by worthy notions like justice, there are no two ways about it. the judgment puts the onus on the banks to ensure that recovery practises are fair; and indeed the liability is rightly , a few would argue, upon the person who has the resources to avoid the damage.
Scratch the surface however and a different pixture would emerge. here's how!

Banks and other financial Institutions forever grapple with the Problem of "sticky assets". Loans that go bad and do not pay returns. The problem is compunded by the fact that the country has no proper restructuring mechanisms and there is government intervention by way of compulsary priority Sector lending. Couple that with the fact that the CRAR ratio-the Capital Adaquecy ratio that they have to maintain is 9%- 1 % higher than the Basel standards that are globally accepted.

let us look at the fall out of this judgment-
banks will be ultra conservative in lending practices. Credit would not be cheap; so,if you are a 20-sth. looking to buy that first house, you buy credit at a higher rate. and you need collaterals and guarantors. The Sub Prime class in India that currently buys credit with the interest rates that range from 25-60% would be the worst hit. I have a belief that these borrowers would be denied credit absolutely. Already poor in terms of income, they would have no recourse to capital.

Additionally, holding banks responsible for the excesses of their agents has reputation costs. Retail borrowers would be less inclined to approach banks for fear of recovery agents; and also because, they are any way not entertained there. They would then look to specialised loan providers like say housing finance Companies and other less prudent entities to finance their needs. these institutions are not diversified (hence risky) and rely on specific sectors for asset creation. Increased sub prime load on their balance sheets mean they become prone to failures themselves.

Thus, while banks have responsibility in ensuring that fair recovery practices are followed, the problems compound when they are held liable. the problem needs policy instruments like Securitisation and more leeway to banks in terms of managing their port folios. Hap hazard innovations by the judiciary will only stall the momentum of the India growth story!