Sudip Bandyopadhyay’s Blog

Lord Mervyn King, Governor of Bank Of England crisply summed up the dilemma of the Governments across the globe when he said that… global financial institutions are global in their life, but national in their death. Each nation has to take steps to ensure that failure of foreign institutions does not disrupt its domestic markets.

Indeed,one of the objective of financial sector reforms  must now be to make sure that, the next time that a major bank founders, there is no need for governments to step in and save other institutions, as they had to do in the aftermath of the Lehman collapse, when they fought to avert a second Great Depression.  So bankruptcy regimes for banks must be improved. Combined with  pushing derivatives on to exchanges, such measures should reduce the chances of a repeat of the severe uncertainty that emerged in the frenzy of last September.

There also needs to be systemic regulation to prevent too many financial institutions from sharing the same vulnerabilities, and from posing avoidable risks to the institutions trading around them.   In Europe and in the US, there is a consensus about the need for such oversight. But this agreement has quickly turned into an argument about which institution should be the Super Regulator and whether such responsibilities can be split. It is more important to decide what regulation is supposed to do. There needs to be political debate about whether regulators should target asset price inflation by varying capital requirements, or simply fortify the banks against crashes. There should be public discussion about whether it is better to make big banks failsafe with thicker capital buffers or force them to slim down so that when they do fail, they fail safely. Policymakers must own up to the fact that there are some institutions they can never credibly claim they will let fail. They must identify who they are implicitly backstopping so they can charge a fee for that insurance. Vague talk of systemic regulation and higher capital ratios is not enough. Politicians need a strategy for making finance safer, and soon.

The collapse or near collapse of several large US securities firms did not pose any threat to the solvency of Indian equity markets because of the margin requirements that we impose on FIIs. Under the doctrine that each country buries its own dead, foreign creditors of a bankrupt FII can lay claim to this collateral lying in India only if there is something left over after the claims of Indian stock exchanges and other Indian entities have been satisfied. In this context, the existence of a large over the counter (OTC) derivative market in India where foreign banks trade without posting margins is a huge systemic risk. Lehman was a bit player in the interest rate swap and other OTC markets in India. As such, its collapse did not create a major disturbance. However, the failure of a large foreign bank which is very active in the OTC market would be very serious indeed. It is absolutely imperative to move the OTC markets to centralised clearing to eliminate this source of systemic risk.