A V Rajwade: A turning point?

WORLD MONEY

After designing more and more complex products, finance now needs a flight to simplicity.

In his article titled "Why the credit squeeze is a turning point for the world" (FT, Dec 12), Martin Wolf argued that "what is happening in credit markets today is a huge blow to the credibility of the Anglo-Saxon model of transactions-orientated financial capitalism." In an earlier letter published in the same journal (Nov 14), Manfred Bienefeld of the School of Public Policy and Administration, Ottawa, Canada, bemoaned the fact that "the current global financial system is a playground for nimble speculators who can take advantage of their favoured position, their better information and their deeper pockets to treat the 'wild ride' as largely an opportunity to make more money."

Bienefeld was criticising an earlier article in FT which welcomed the recent change in management at the top of Siemens: apparently, the newcomer is somebody who "pays close attention to what the capital markets want", in contrast to his predecessor who "prided himself on balancing shareholders' interests with those of workers, politicians and other stakeholders."

Another instance of the close attention to what the capital markets want: despite the skyhigh oil prices and quadrupling of operating cash flows, exploration spending by the "Big Five" oil companies fell from $10 bn in 1997 to $6 bn in 2005! The reason? Exploration spending reduces quarterly profits. The tyranny of Wall Street, of major companies contributing hugely to the real economy having to manage themselves with the sole objective of "meeting Wall Street (or Dalal Street) expectations" is another manifestation of the Anglo-Saxon model of financial capitalism.

Commercial and investment banks are of course the spearhead of finance capitalism. In earlier columns, I have criticised the tendency of finance capitalists to beat the drum of unregulated freedom when times are good, but to desire to be rescued with public money when in trouble. Recent weeks have shown yet another instance: commercial and investment banks are falling over themselves in getting capital from the so-called sovereign wealth funds to improve their capital ratios. As one looks forward to the new year, one is apprehensive that the greed of the dealers and traders in the "originate and sell", transaction-oriented model of banking, and its fallout, could affect the world economy and growth in the coming year. The illiquidity in the secondary market for investments in derivative securities in particular, is leading to a chain of events:

The losses on the portfolios, whether through mark-to-market or because of actual sales, are reducing the capital of major banks. The declared losses of major banks amount to something like $100 bn;

Simultaneously, they are having to take back on their books the investments in the so called "special investment vehicles (SIVs)", off balance sheet entities sponsored by them. (The reason is that the asset-backed commercial paper market, which was financing them, has collapsed.) One of the first decisions of the new Chief Executive of Citibank was to take back on its books such assets totalling $58 bn! Many other major banks have had to take similar steps. Overall, even as capital comes down because of the losses, the size of the credit portfolio is going up;

Given the capital ratio prescribed by Basel-II, the inevitable result of the first two factors would be a slowdown in credit growth, if not an actual contraction.

In fact, the rigid capital norms are constraining the banking system's ability to act countercyclically in economic slowdowns, something which Mervyn King, the Governor of the Bank of England, had apprehended a few years back.

Another pernicious effect of the dominance of finance capital has been, to quote Wolf once again, "the shifting of the risk on to the shoulders of those least able to understand it." We in India are also witnessing this phenomenon in the form of complex and leveraged derivatives marketed to a large number of SMEs in the guise of "hedging their foreign currency exposures".

Several cases of large losses have been reported in the press, in some cases threatening the very viability of the companies. In many cases, the counterparty banks are not even lenders to the companies and have little interest in them beyond marketing highly profitable transactions, disregarding the suitability or appropriateness of the transaction, let alone the customer's ability to understand, appreciate and manage the attendant risks.

Innovation to invent a better mouse-trap is one thing: innovation aimed at creating ever more complex financial products to hide price "" and risk "" implications is another. As even The Economist acknowledged (Dec 22), "Finance now needs a flight to simplicity" "" including in the derivative market in India. Will the new year be a tipping point in the dominance of finance capital as Wolf expects?
Happy New Year!

avrajwade@gmail.com