The financial and economic meltdown in G7 nations has had a negative impact on growth in India and other developing countries. Could anyone seriously believe that there is some form of financial alchemy which consistently provides returns on capital well in excess of national GDP growth rates and the major equity and bond indices over decades?
In the financial services sectors rates of return on equity can be raised without improvements in the efficiency with which capital is allocated. This can be done by increasing leverage, ie by raising a firm's debt-to-equity ratio. If the rate of return on total assets is more than the cost of debt, the return on equity balloons up as leverage increases.
It also follows that for highly leveraged companies, if there is a small reduction in asset prices, the firm's equity capital will be wiped out. Asset price bubbles have burst at periodic intervals. For instance, the IT boom went bust as recently as 2001-02. It is not credible that everyone in regulatory circles was under the impression that prices of mortgage-backed securities would never correct.
The only way I can square this circle is that political economy factors were at work. Mancur Olson suggested in his 1965 book, The Logic of Collective Action: Public Goods and the Theory of Groups, that a limited number of influence peddlers who have much to gain from particular policies can prevail even if these policies are inefficient for society at large.
Further, such policies are adopted even if the huge gains for a few are cumulatively less than the losses for society since the latter's losses are distributed over a large numbers of losers.
The US is engaged in costly procrastination on whether to openly nationalise its largest banks and insurance companies. In some circles it has been suggested that mark-to-market accounting rules should be temporarily suspended. In the UK, the Bank of England is pondering on the extent to which it should resort to quantitative easing.
Why is any of this of interest to India? Clearly, Indian equity markets, exports and overall economic growth have been hurt by the slowdown around the world. Further, in the last few years some commentators have called upon policymakers and regulators in India to push for the following: (a) the central bank to adopt inflation targeting as its principal objective; (b) move speedily towards capital account convertibility; (c) raise foreign direct investment ceilings in the Indian banking sector; (d) move from defined benefit pensions schemes to defined contributions and favour larger investments in equity markets; and (e) establish Mumbai as an International Financial Centre.
We need to pause and reconsider all of the above propositions. As we know, the performance of chief financial officers is crucial in any firm. However, no real sector company or financial institution should allow itself to become too dependent on income from its trading (treasury) activities.
Consequently, I would suggest that government support should focus on widening financial inclusion and our all too familiar problems of providing primary education and basic health facilities. Any residual resources are better spent on promoting innovation in real sectors.
A large body of academic and practitioners' literature about the financial sector, which was developed in the West, highlights efficiency gains derived from innovation in financial services and why this is best achieved by the private sector. India has copied many of the regulatory structures, policies and practices of the financial sector in the developed West.
However, the Indian banking, insurance and pensions sectors are still predominantly in the public sector and the inefficiencies and wrong-doing in Indian public sector financial institutions are well-documented. And, despite all the on-going 'leakage' these institutions have not as yet caused a systemic breakdown in credit markets such as we are witnessing in developed countries.
It does not appear that prominent bankers, brokers and asset managers in India or elsewhere ask themselves: what exactly is the additional value of their services, as compared to the real sectors, for their compensation packages to be so much higher?
The supporting arguments that financial sector personnel have rare discerning capabilities to take judicious risk and that their innovations are complex are not credible. In terms of risk, it is the tax-payers who provide the back-stop and end up supporting private sector financial institutions if there is a danger of systemic failure.
The boards and managers of larger financial institutions cannot be allowed to fail. Inevitably, at a time when a nation's financial-economic house is on fire the plea is that now is not the time to worry about moral hazard and how to prevent a future crisis and that government funds should be used to douse the flames.
Additionally, it cannot be anyone's case that the underlying mathematics in mortgage securities, credit default swps and derivatives in general is technically more demanding than quantum mechanics or rocket propulsion technology.
A 1994 paper by George Akerlof and Paul Romer, which was titled Looting: The Economic Underworld of Bankruptcy for Profit examined various financial crises of the 1980s including the savings and loans, thrifts and junk bond-related insolvencies.
One of the conclusions of the paper was that 'bankruptcy for profit will occur if poor accounting, lax regulation, or low penalties for abuse give owners an incentive to pay themselves more than their firms are worth and then default on their debt obligations'.
In this context, it was probably not just public sector ownership and lack of capital account convertibility which insulated our financial sector from the egregious Lehman Brothers and AIG kind of risk-taking. The CEOs of our large financial institutions do not as yet have a high enough personal gain incentive to take risks which could render their firms insolvent. Take the Madoff and Stanford cases.
Obviously, these Ponzi schemes are not representative of problems caused by the use of complex derivatives. The huge payoffs involved were probably an important factor that distracted regulators. My sense is that no amount of overhauling of the regulatory and credit rating processes can reduce systemic risk in the financial sector unless it is accompanied by a clipping of compensation packages to make these comparable to other sectors.
The author is Ambassador of India to the European Union, Belgium and Luxembourg. Views expressed are personal
