Sudip Bandyopadhyay’s Blog

Alan Greenspan, the former US Federal Reserve chairman, confessed that he had failed to anticipate the financial crisis and said “Those of us who have looked to the self-interest of lending institutions to protect shareholders’ equity (myself especially) are in a state of shocked disbelief.” Mr.Greenspan had faith that banks were prudent enough to make sure they were not lending money cheaply to people who could not pay it back. Yet that is what happened. How did Mr Greenspan, along with the rest of the world’s regulators, fail to foresee that this could happen? Probably the mistake was to neglect the role of human nature. To prevent future catastrophes, regulators, amongst others,  may also need to focus explicitly on how to provide safeguards against two all-too-human frailties explored by decades of work in behavioral economics: bounded rationality and limited self-control. The standard non-behavioral economic model has greatly influenced regulators. In that model, economic agents choose optimally, no matter how hard a problem they face. The problem with this approach is that the world is populated by humans, not economic agents. Humans are not stupid, but when things get complicated they flounder: they suffer from bounded rationality. This brings us to an aspect of the financial crisis that has not received the attention it deserves: the financial world has become more complex in the past two decades.  Probably it is high time that Regulators across the globe  try  &  simplify / clarify  things without stifling innovation. The second problem involves self-control. Economic agents do not suffer from self-control problems and so “temptation” is not a word that exists in the  non behavioural economists’ lexicon. As a result, regulators may  not have thought much about the problem. But when the dessert cart comes by, we humans often cave in. The next thing we know, we are fat.  Greed and corruption helped create the crisis in the international markets, but simple human frailty played a vital role. We will not be able to protect against future crises if we rail against greed and wrongdoers without looking in the mirror and understanding the potentially devastating effects of bounded rationality and limited self-control.

Financial crisis causes lot of damage, and ill-conceived post-crisis measures, no matter how well-intended, can only magnify their effects. The Smoot-Hawley Tariff Act of 1930, a US law that erected trade barriers, is widely regarded as having added considerable strain to the world economy after the 1929 stock market crash.  However, the Oscar goes to the British authorities: after the South Sea Bubble collapse (1720) they banned issuing stock certificates for more than a century.  Now securitization is the black sheep and many transactions structured around sub-prime mortgages have performed disastrously.  But blaming the current crisis on securitisation in absurd.  Unfortunately, there is a real danger that  public outrage might end up producing counterproductive regulation.  Securitisation is just a technique to create securities by reshuffling the cash flows produced by a diversified pool of assets with some common characteristics.  By doing so, one can design several securities (tranches) with different risk reward profiles which appeal to different investors.  An erroneous assessment of the risk characteristics of the underlying assets, the use of faulty models to examine the merits of each tranche, or an imprudent reliance on leverage can lead to calamity.  This is what explains the debacle behind the subprime transactions. By creating securities out of illiquid assets, securitisation increases liquidity.  Second, for companies that have assets with predictable cash flows, securitisation provides an alternative form of financing.  And third, lending institutions can use securitisation to manage the credit exposure more efficiently, which, in turn allows them to make more loans. All these benefits are critical & Securitisation, if used properly, makes access to credit more efficient.

The Indian Markets witnessed extremely high volatility during the last week  and sentiment were adversely affected by weak global cues. A significant observation was that the sharp rise seen in indices last week could not be sustained at higher levels due to continued unwinding of stocks by the FIIs in the cash segment, resulting in both the NIFTY and the SENSEX once again closing below critical support levels of 3000 and 10000 respectively.   Markets started the week on a promising note with China announcing a record 4 trillion Yuan ($586 bn) stimulus package to spur expansion and bolster the Chinese economy, which accounted for 27% of global economic growth last year. Incidentally the package announced is equivalent to a fifth of the chinese $3.3 trillion GDP last year and a major part of this package will go towards low cost housing, infrastructure in rural areas as well as Roads, Railways and Airports. The Chinese move cheered all the Asian markets including ours and we had a firm start to the week.  However global news flows from the US markets during the week continued to show depressing signs of a long and deeper  US slowdown  ahead, with several  US corporates announcing huge losses.

On the positive side, the  Indian IIP numbers for Sept 08 showed a strong rebound to 4.8% from 1.3% recorded  in Aug08, which was driven by strong growth by the Capital Goods (up 18% YoY) and consumer durables (up by 13% yoy). Another silver lining was sharp fall in domestic Inflation numbers for the week ending 1st Nov 2008  to 8.98% which is the lowest in last 21 weeks. The fall in Inflation was primarily driven down by declining prices of fuel and manufactured goods. The sharp fall in inflation to single digit, much earlier then expected is likely to trigger ‘Rate cuts’, which could spur economic growth. RBI & the Finance Ministry have been taking continuous proactive steps since the International Financial crisis broke out few months back and the current drop in domestic inflation should encourage them to take further relevant action expeditiously.This augurs well for the markets going ahead.  Meanwhile global crude prices have now weakened further with the Indian crude oil basket price moving below $50 a barrel which effectively could also result in  a cut in diesel and petrol prices in the near term. Despite positive news on Inflation and IIP front, the markets failed to recover, which clearly indicates continued selling by FIIs . In the coming week cautious approach could be seen being adopted as once again global cues will remain drivers for the market. Any measures by RBI like Rate cut or CRR cut may trigger a short term rally, as markets are now in an  ‘oversold’ state.

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