C. Rangarajan, ex- RBI governor and member Rajya Sabha, speaks on where India stands today and what needs to be done
evolution of the crisis
The international financial crisis originated in the sub-prime mortgage crisis which surfaced nearly two years ago in the US With interest rates rising and home prices falling, there was a sharp jump in defaults and foreclosures. However, this would have remained as a purely mortgage market crisis but for the fact that these sub-prime mortgages were securitised and packaged into products that were rated as investment grade. Once doubts about these assets arose, they turned illiquid; it also became very hard to price them. As a result, it started affecting a host of institutions which had invested in these products. These institutions were not confined to US alone. Financial institutions in Europe and to a much lesser extent in East Asia had such assets on their books. With the failure of a few leading institutions and most notably Lehman Brothers, the entire financial system was enveloped into an acute crisis. There was mutual distrust among the financial institutions which led to freezing up of several markets including the overnight inter-bank market. Many think today that letting the Lehman Brothers to fail was a great mistake. The crisis in the financial system has now moved to affect the real sector in a significant way.
regulatory failure
What stands out glaringly in the current episode is the regulatory failure which was twofold. First, some parts of the financial system were either loosely regulated or were not regulated at all, a factor which led to “regulatory arbitrage” with funds moving more towards the unregulated segments. The second failure lies in the imperfect understanding of the implications of various derivative products. In one sense, derivative products are a natural corollary of financial development. They meet a felt need.
However, if the derivative products become too complex to discern where the risk lies, they become a major source of concern. Rating agencies in the present episode were irresponsible in creating a booming market in suspect derivative products. Quite clearly, there was a mismatch between financial innovation and the ability of the regulators to monitor them. It is ironic that such a regulatory failure should have occurred at a time when intense discussions were being held in Basle and elsewhere to put in place a sound regulatory framework.
The international financial crisis originated in the sub-prime mortgage crisis which surfaced nearly two years ago in the US With interest rates rising and home prices falling, there was a sharp jump in defaults and foreclosures. However, this would have remained as a purely mortgage market crisis but for the fact that these sub-prime mortgages were securitised and packaged into products that were rated as investment grade. Once doubts about these assets arose, they turned illiquid; it also became very hard to price them. As a result, it started affecting a host of institutions which had invested in these products. These institutions were not confined to US alone. Financial institutions in Europe and to a much lesser extent in East Asia had such assets on their books. With the failure of a few leading institutions and most notably Lehman Brothers, the entire financial system was enveloped into an acute crisis. There was mutual distrust among the financial institutions which led to freezing up of several markets including the overnight inter-bank market. Many think today that letting the Lehman Brothers to fail was a great mistake. The crisis in the financial system has now moved to affect the real sector in a significant way.
regulatory failure
What stands out glaringly in the current episode is the regulatory failure which was twofold. First, some parts of the financial system were either loosely regulated or were not regulated at all, a factor which led to “regulatory arbitrage” with funds moving more towards the unregulated segments. The second failure lies in the imperfect understanding of the implications of various derivative products. In one sense, derivative products are a natural corollary of financial development. They meet a felt need.
However, if the derivative products become too complex to discern where the risk lies, they become a major source of concern. Rating agencies in the present episode were irresponsible in creating a booming market in suspect derivative products. Quite clearly, there was a mismatch between financial innovation and the ability of the regulators to monitor them. It is ironic that such a regulatory failure should have occurred at a time when intense discussions were being held in Basle and elsewhere to put in place a sound regulatory framework.
Source : IIPM Editorial, 2012.
An Initiative of IIPM, Malay Chaudhuri
and Arindam Chaudhuri (Renowned Management Guru and Economist).
and Arindam Chaudhuri (Renowned Management Guru and Economist).
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