Sudip Bandyopadhyay’s Blog

The world has not ended. The International economy has not yet collapsed. But one thing is now quite clear: the US banking system as we know has failed.  Following the disappearance of Bear Stearns in March and now the bankruptcy of Lehman Brothers and the surprise plans for Bank of America to absorb Merrill Lynch, three of Wall Street’s five big independent investment banks have disappeared inside six months.  After an astonishing week it is too early to predict the future shape of investment banking with confidence, but business as usual is not one of the possibilities. The future of Goldman Sachs and Morgan Stanley, the last two independent investment banks, is now an open question.  Goldman has survived not because of a fundamental difference between it and Bear, Lehman and Merrill, but because it took more successful bets.  Investors may be happy to bet that the run of success will continue, but regulators may not: and expectation is that capital requirements will be tightened.

The failure of this independent Investment Banking business model is not just about the continued impact of US housing but symptomatic of a more fundamental malaise that will continue to damage the US and Europe.  As the US current account deficit grew towards 6 per cent of gross domestic product, the repackaging of US mortgage debt into AAA products allowed Asian and Middle Eastern surpluses to be recycled into the US and allowed the investment banks to grow rapidly. Their “originate to distribute” model came unstuck as foreign investors realized that the products they had been sold were not AAA, but CCC.  This withdrawal of private sector foreign funding is the main factor behind the weaker dollar, lower US asset prices, higher savings, the sharp contraction in the US current account deficit and the consolidation within US financials.

There will now be renewed calls for more regulation, and understandably so.  But it is naïve to think that the right regulatory response is obvious.  From poor governance to flawed incentives, incompetent risk management to foolish strategies, the failures of the financial system have been so widespread as to render a coherent regulatory riposte impossible.  The likely outcome is that tight capital requirements will be forced to serve as a catch all response to risk.  If so, the US banking system will look more like that of the 1960s – a low-risk, low-return utility business.  The ambitious and the avaricious will no doubt seek more exciting hunting grounds with hedge funds and private equity groups.

Indian Capital markets cracked significantly during the last week on sustained FII selling following negative global headwinds arising from the bankruptcy of Lehman Brothers, AIG bailout by the Fed and the overall loss of confidence within the US markets. Globally the US markets continued to reel under panic throughout the week and sent panic waves across the globe and markets like China, Japan, Russia and UK were also badly hit. In fact the spate of bad news globally started escalating last week with several hedge funds closing operations. This triggered a panic situation in financial markets, and resulted in banks shying away from funding to other financial intermediaries thereby increasing dollar borrowing costs.   Nevertheless Fed decided to maintain interest rates steady at 2% and did not cut rates as expected by the markets.  Although stringent measures now are being taken by U.S. Fed to tide over the financial crisis, effects are largely to remain temporary.

These factors completely over shadowed all the positive news flows in the domestic markets, especially pertaining to lower crude prices which continued to soften during the week and in between touched $91 a barrel.  Inflation for this week increased mildly to 12.14% from the earlier level of 12.10% largely on account of a rise seen in food articles.  With crude prices now softening and agriculture production also on track, one should see inflation moderating going ahead in the next 2-3 quarters.   Some more positive macro numbers released last week also saw Indirect tax collections including customs duty, excise duty and service tax having achieved 35% of the budgeted target for 2008-09 between April-Aug08. Also on the Agriculture front, the government is confident of exceeding the current Kharif production target of 84 mn tones which is over and above the earlier all time high achieved target of 82.81 mn tones in 2007.

FIIs remained net sellers in the Indian markets and rupee depreciation reflected money outflow from domestic markets. Most of the action reflected portfolio selling from the troubled FIIs.  During the last week FII’s sold stocks worth almost $1 bn in domestic markets. The smart recovery towards end of the last week was triggerred by domestic institutions finally taking the plunge and doing some value investing.  Even HNIs and Retail Investors  started buying blue chips from Thursday second half at  the available compelling valuations. Going ahead in the expiry week, markets may see a mild extension of gains however profit booking around “expiry” time is not ruled out. More importantly FII selling is not yet fully over and the global markets would be keenly watching further news flows pertaining to bigger remaining investment banking players like  Morgan and Goldman. Any negative news flows from global arena can once again derail the existing positive momentum in domestic markets.

( ** this is the transcript of the weekly column I write for Economic Times )