The key to building stable financial systems

India has been transiting from a centrally planned, government-dominated to a market-oriented economy ever since the reforms began in 1991.

There is wide consensus that the first phase of reforms has been concluded successfully which ensures a sufficiently meaningful role for market forces, while acknowledging that the government still holds a big sway over the economy.

Future reforms include a significant quantum of financial sector measures to make them more market-oriented. As India grapples with the future reform agenda, the global financial markets have been in turmoil.

This crisis has highlighted the limitations of the market system and reinforced the central role of the government and regulators in developing stable financial systems. While there are significant lessons to be learnt on why markets fail and the desirable role and engagement of the government and regulators in the conduct of markets, it is important that India continues to pursue its reform agenda.

The Indian financial system needs considerable toning up as yet in terms of its size, inclusivity, transparency, efficiency and coverage to continue to be relevant to the growing Indian economy.

On the one hand, there is merit in considering how much the regulatory restrictions that exist in India prevented the kind of difficulties that the USA and Europe are undergoing.

These would be in areas such as moderate leverage, bank exposure to segments that are more prone to asset bubbles such as real estate and stock markets, structured finance markets, etc.

The savings channels are pretty much aligned to bank deposits and lend considerable stability to the financial institution system in India as it is predominantly government-owned and hence give rise to perception of relative safety.

Gordon Brown, the prime minister of the United Kingdom, is widely acclaimed for his move to 'nationalise' banks in his country and thereby show the right path out of the panic-ridden global financial mess in recent times.

Even though the UK government proposes to hold only a minority position in these banks, the word 'nationalise' was used to perhaps convey strongly the message that these entities were under sovereign protection, to hope that the financial markets get more comfortable dealing with them.

Apparently, the trick worked and early indications are that the panic has subsided. Ironically, this reception is in complete contrast to the less than cordial reception that greeted the Indian government's proposal to dilute its holding in Indian banks to a third of the capital while still maintaining their 'public sector' character a few years ago!

In both situations the objective was to leverage a minority holding by the government to reassure the markets that the institutions had system support, while allowing the bank to find outside capital to support its growth and serve a bigger market. That the government needs to stand by even the pure commercial institutions, even if it had no shareholding, was clearly demonstrated by the quick expansion of panic which arguably destabilised the wider markets when Lehman Brothers collapsed in the USA.

But this support can't and will not come without the government and regulators acquiring control on the activities of these institutions, including acquiring ownership. Developing countries such as India cannot afford the costly corrective mechanisms of the market to get its economic development right.

However, some of the regulatory restrictions such as branch expansion and use of counterparties leave as much as 40 per cent of the population under-served. There are also several vital markets and players that are missing such as corporate debt and interest hedge markets.

These restrictions also mean considerable delays in getting new products to markets, even if they are desirable. The financial system is still too small as compared to the size of our economy and will need to be considerably strengthened and expanded to carry the burden of financing the higher rate at which our economy is now growing.

Resort to banning of markets, unexpected regulatory intervention in the market either through market operations or policy initiatives or through blunter measures such as banning markets, players or products leave markets unsettled and uncertain about their future status and lessen their commitment for long term sustainable growth.

The government/regulator also extracts some management autonomy from such institutions as are under its control in terms of executive compensation, product and markets decisions, pricing and extension of the institutions operation to certain priority segments that the government wants to promote and in appointment of key management personnel and in being an employment provider for the society at large.

Obviously, some of these are good for the system as a whole. But some of these measures become inefficient as their performance objectives are not clear and hence immeasurable, and ultimately become a complete burden on the government instead of making the financial institutions tools of policy which the government can leverage to promote financial stability and economic growth.

It is clear that a government-market partnership needs to exist to serve the economy most optimally. The objective of this partnership should be to leverage the sovereignty of the government to induce faith, stability and discipline into the financial system of the country with the flexibility, enterprise and capital of the market forces to expand the system to serve a wider cross section of the country's population.

The moral hazard is that the market might take more risk than it can afford if it believes that the government or the regulators will bail it out. On the other hand, not playing any role in any part of the financial markets could leave that section as a potential source of systemic risk.

There is also the tendency to treat the financial institutions and markets as separate silos of the financial system. However, it is apparent from recent events that both the institutions and the various financial markets are part of the same continuum and that there are no safety-walls that separate the two.

However much the regulators wish to keep them separate, there will continue to be a flow of funds and cross exposures to each other. When such exposure reaches unsustainable levels, there will be risk overflow from one system to the other. Therefore, creating artificial barriers and not dealing with these sub-systems in a unified or coordinated manner might be sub-optimal.

The key is to get the government's role in the financial institutions so far as to impart systemic stability but to desist from making it a public policy role. The key also is to ensure that the increasing coordination within the regulatory system is accelerated.

This will ensure fuller and fairer disclosures are made to the regulators and policy makers so that timely action can continue to be taken to ensure financial stability.

These policies should also allow a disciplined, deep and healthy market which is able to bring creativity, enterprise and additional capital to play to include a much wider cross section of our population than would be possible only with government funds to ensure we have stable, sustainable and inclusive financial system in our country.

For this, the markets need clear, transparent and simple rules on their expected behaviour and what to expect from government policy and when and where will government/regulators intervene. 

The author is the Managing Director & Region Head of Standard & Poor's, South & Southeast Asia. Views expressed in this article are personal.