Abheek Barua: Lessons from the financial crisis

If we stay on the current growth trajectory, there is bound to be much more expansion in credit to riskier segments.

The advantage of falling behind the curve in terms of financial market development is that, hopefully, we get to learn from others' mistakes. There is, I'm sure, much that Indian markets can learn from the current global financial crisis that has stemmed from large default in the American mortgage market. It is important, however, that we learn the right lessons and not allow events around lead us into an obscurantist financial policy regime.

While the current financial meltdown is driven by huge losses in the high-risk sub-prime housing loans market, it is also being viewed as the darker side of the "structured finance" boom of the last four or five years. Structured finance refers to a plethora of instruments ranging from the simplest securitised loans to the more complex collateralised debt obligations (CDOs). These may appear somewhat exotic to the lay person but all that they do, in effect, is to enable the original lenders (banks, for instance) to pass these loans on to those who had an appetite for these riskier assets (hedge funds, say). This led to enormous growth in this market "" current estimates of the US sub-prime mortgage market are now $550-600 bn.

There would be a natural tendency to dismiss these instruments in the wake of the recent problems, perhaps even a clamour to come down with a heavy hand in regulating these instruments. That would be a trifle naïve. If economic growth has to sustain, it is imperative that markets for higher risk credit be allowed to thrive. This is particularly true for India with its problems of low credit penetration and shallow bond markets.

Historically, Indian banks have stayed away from lending to segments that have had the faintest whiff of risk. Given a chance, banks would prefer an asset of portfolio consisting of stodgy low-return blue-chips than take a chance with the odd promising but risky entrepreneur. There was some change, though, in the last few years. Loan securitisation, for one, made some headway. Better credit information is now available on both retail and smaller corporate borrowers. The credit boom in India of the last four years has come not on the back of increased lending to blue-chip companies or individuals with assured high-income streams. It was been driven by banks' willingness and enhanced ability to take more risk on their books. I would argue that this was a critical ingredient in pushing us on to a new growth trajectory.

If we are to remain there, it is imperative to ensure that this process gains momentum. That means more structured finance products in our credit markets and deeper, more sophisticated bond markets. Certainly not less!

What are the lessons to be learnt then? Clearly there is a message in all this for the credit rating companies. I do not claim to be an expert but from whatever little I understand of it there does not seem to be anything grossly wrong with the methodology of rating these structured products. I certainly do not subscribe to the now popular conspiracy theory that the rating companies in league with structured product marketers vetted the issue of junk credit as high investment grade instruments. The methodology and safeguards that were used are reasonably transparent. Instead the key problem with the current paradigm of ratings that the crisis puts its finger on is its inability to predict large-scale default adequately ahead.

This is not a new issue. Credit ratings seem to reflect the probability of default very well in normal circumstances. However, raters just don't seem to be able to raise the red flag early enough when it comes to large-scale default. (The Asian crisis is incidentally another example.) If the rating agencies are to regain credibility, they just have to find a way of getting this right.

There is a deeper question that the current crisis raises and that's one that central banks need to answer. Can monetary policy be driven entirely by the diktat of headline inflation and growth? Or does the quantum of borrowing in the economy and possible impact on borrower behaviour become an important factor in determining interest rate decisions?

Let me put this in context. The rise in default rates in the sub-prime market is essentially due to two things. Most borrowers got into adjustable rate mortgages where the interest rates were reset periodically. Second, as the US Fed relentlessly hiked policy rates (17 times between 2004 and 2006), mortgage rates rose as much as 40 per cent. Sub-prime borrowers, characterised by low and often volatile incomes, found that they could not service their loans any longer. The result is the large default across the board, which plagues the markets. I would argue that the Fed has to shoulder at least part of the blame for the current mess.

Perhaps the US central bank could have been a little more prescient and figured out that the series of rate hikes had the potential to trigger a crisis of this kind. The existence of the large quantum of sub-prime assets and the impact of mortgage rate resets should have figured more actively in their monetary policy discussions much earlier. Finally, if the Fed had felt that the excess liquidity was whipping up too much froth in the housing market, it should have excised the problem much earlier than allowing to fester. I would agree that this financial crisis is a way of bringing about a much-needed correction in asset markets.

These lessons are particularly important for the RBI. If we do stay on the current growth trajectory, there is bound to be much more expansion in credit to increasingly riskier segments. The central bank will have to facilitate this expansion and balance this with the more conventional role of inflation management. It has to make sure that it doesn't throw the baby out with the bathwater.

The author is chief economist, HDFC Bank. The views here are personal