August 2012 marked five years since the global financial crisis erupted on an unsuspecting world, bringing substantial and continuing human misery in its wake. It also marked the transition of Raghuram Rajan from part-time honorary advisor to the prime minister to a full-time position as Chief Economic Advisor to the government, based in the ministry of finance.
Dr Rajan is one of the few academics to have expressed unease at the level of systemic risk accumulating in global finance well before the crisis expressed itself. This was in 2005, at a time when many of his professional peers were basking in self-congratulation. The basis for this complacency was the record on inflation which seemed finally to have been tamed in the 1990s after a wild ride in the 1970s and 1980s.
Dr Rajan was also the chair and principal author of the Committee on Financial Sector Reforms convened under the Planning Commission at the time of UPA-I, an exercise with which I was associated as a member*. That committee’s report was finalised just as the financial crisis reached a more acute phase with the bankruptcy of Lehman Brothers, to be followed by the parliamentary elections of 2009. Now that the UPA-II government is once again flirting with reform, it is not impossible that its attention will move to the financial sector, even though its legislative room for manoeuvre may be limited.
My principal focus here is on the debate in the advanced countries. Many of these insights have been gleaned from conferences and workshops subject to what is called the “Chatham House Rule”. Under this rule, participants are permitted to reveal the event and the substance of what was discussed, but not to attribute ideas to individuals present. To avoid charges of plagiarism, let me readily admit to benefiting from discussions at the Aspen Program on the World Economy in Aspen, Colorado; the Annual Conference at Bruegel, a respected think tank in Brussels; and an EU-India business summit titled “Prabodhan” held recently in London. Interpretation and synthesis remain personal.
The areas of ferment fall in three broad areas: the goals and conduct of monetary policy; the regulation and supervision of cross-border banking; and dealing with risk, moral hazard and perverse incentives in large financial institutions.
At the outset, I would offer two broad observations. First, while the crisis has dramatised the linkages, tensions and conflicts of interest, and there has been feverish policy action, the dominant sentiment in academic and policy communities remains one of frustration and helplessness. The beast is far from slain.
Second, while finance has broadened over the decades to be about much more than banks, at the end of the day it is banks that persistently create the most damaging, intractable and expensive problems for states and societies. As one much-followed commentator noted at Prabodhan, the central lesson of this episode is that the fortunes of states and banks are deeply intertwined, and that banks can bring down states, even in rich countries.
In the area of monetary policy, there are both the lessons from the past and challenges of the present. As to the latter, we are clearly experiencing an extraordinary period of monetary adventurism at present. Policy makers at the European Central Bank (ECB) and the United States Federal Reserve are following their Japanese colleagues in struggling with “policy at the zero lower bound”, what Keynes called the liquidity trap. Whether this will end in more tears or a few smiles is yet to be seen. As Alan Blinder noted at Jackson Hole, also in August, exceptional times call for exceptional measures.
Equally interesting is the post-mortem on the past. As one senior policy maker noted in a private conversation, it is not clear that the major economies were growing above trend before the convulsions of 2007. As for financial stability, it is sobering to remember that Spain’s central bank was one of those that was praised for having put in place a system of so-called “dynamic provisioning”. Yet that action, while worthwhile, has not been sufficient to save Spain’s banks, or Spain itself from considerable and continuing agony.
The miseries and contradictions underlying cross-border banking have been most painfully evident in Europe, as a deeply integrated banking system faces national responses to the crisis. Bankers at Bruegel noted that national regulators have fragmented what used to be a common financial space. While the proposed move to banking union in the euro zone is designed to stem this rot, the political manoeuvring by national governments demonstrates the concern for involuntary transfers by taxpayers across national boundaries via such mechanisms as integrated deposit insurance and common resolution authority.
Finally, on the issue of “too big to fail”, the official response has been to boost regulatory capital within the framework of what has come to be called “Basel III”. Yet as pointed out by Andy Haldane of the Bank of England, again at Jackson Hole, fighting complexity with complexity may not be the correct approach. Nor is there consensus on the safest banking business model. Some, including India, continue to prefer universal banks; others the rigid separation between commercial and investment banking which was the norm in the US under the Glass-Steagall Act of 1932 repealed in the 1990s. This is to be resurrected under the so-called Volcker Rule proposed by President Obama, fiercely and largely successfully opposed by the banking lobby.
Do these debates matter for India? The linkages between banks and the state are very tight here. Banks hold significant government debt; all public sector banks effectively are too big to fail. And yet, banks remain fundamental to India’s growth. The Reserve Bank of India governor has done the nation service in pointing out how political and fiscal constraints hold back the public sector banks, even as the licensing of new private sector banks is on hold.
Second, and notwithstanding the above, India’s financial sector is likely to be among the fastest growing and in due course one of the largest in Asia. Concomitantly, Indian banks will seek to expand their footprint in Asia and Asian banks in India. India is also likely to be a net importer of capital for some time to come, despite its own relatively robust domestic saving rate. It will be important to limit our potential fiscal liability as this process gathers steam.
*A hundred small steps: Report of the Committee on Financial Sector Reforms (Sage and Planning Commission 2009)
The writer is chief economist, Shell International.
These views are his own
