The Financial Turmoil - Effects, Reforms and Investment Strategies

by arnabmoitra11 (student)

University Degree Business and Administrative studies

The Financial Turmoil

Effects, Reforms and Investment Strategies

IMI, New Delhi

Arnab Moitra, Manish Banga

The game continues

In the fifth year of a financial crisis, Europe is still trying to right itself, joblessness stays high in the U.S., and China’s ability to escape the depression in the West remains an open question. The recent Libor scandal and the trading losses at JPMorgan have brought further unwarranted criticism for the banking industry.

The drumbeat of a financial crisis globally is getting louder by the day. Consider the evidence:

Greek elections throwing the entire Euro-zone into existential and financial turmoil: This had ensued a financial panic and had brought two pre-emptive bailouts: $125 billion to Spain's banks and $100 billion in England
The ill-preparation and weaknesses of banks are coming to the fore again: Moody's is concerned about banks; the ratings firm promised to embark on a downgrading spree - the major casualty of which would be Morgan Stanley.

The increasing size and complexity of financial linkages between countries have increased the risk of rapid and simultaneous shocks between countries, with dramatic consequences for economic conditions.

There will always be a next crisis

Crises continue to come, even with intense oversight exercised by the authorities. One reason is the natural tendency of government officials to fight the last battle, i.e., looking for systemic weaknesses unfolded by the most recent crisis. Reforms are necessary; however, we cannot stop tomorrow’s crises by looking backward. Flaws in the regulatory and supervisory apparatus will be exploited in the name of innovation. Managers of financial institutions are always on the lookout for the boundaries defined by the regulatory apparatus, and the more detailed are the rules, the more ingenious is the avoidance. These strategies will continue since this brand of ingenuity is handsomely rewarded.

Figure 1: Identifying systemic crises

Source: World Economic Outlook database and IMF staff calculations

Our current economic regulations are not just neutral but they are outright perverse. If a bet with a positive payoff is available in exchange for a chance of crashing the bank and along with it the economy, it is the fiduciary duty of the executives to take this bet because it maximizes shareholder wealth. JP Morgan Chase, for instance, had predicted, to the tune of $100 billion that we are hurtling towards a financial crisis this year. Its "London Whale" trade - a complicated $100 billion ...

This is a preview of the whole essay

Figure 1: Identifying systemic crises

Source: World Economic Outlook database and IMF staff calculations

More to RBI than just inflation targeting

The RBI, as a supervisor, has expertise in evaluating the banking sector conditions, the payments systems, and capital markets as well. Such evaluations must be done very quickly when financial stability is threatened or when there is fear of the spread of problems in one institution. In other words, appropriate actions require that bank supervisors and monetary policymakers internalize each other’s objectives and separation of duties makes this difficult.

In their daily interactions with banks and other financial institutions, RBI needs to manage credit risk both in their lending operations and in the payments system. Central banks worldwide take on credit risk as the lender of last resort. To do so in a responsible manner, information about the borrower is needed, which is almost impossible without having complete and fast access to supervisory information.

The only insurer against liquidity risks is the RBI. If it does not control those who create credit and liquidity, it will continue to induce agents to create massive amounts of liquidity, thereby endangering the financial system. Operations in the middle of a financial crisis are quite similar to maneuvers during a war. Separation of supervision from the central bank is akin to having two generals with potentially different objectives and giving orders to the same army!

The Alliance

Tackling the systemic risks prevalent in the financial system is possible by forging an alliance between financial institutions and the central bank, which would help in the following:

Clarify the relative riskiness of assets by fostering standardization of securities and encouraging trading on organized exchanges.
Root for a well-designed, rules-based deposit insurance scheme, essential to protecting the banking system from future financial crises.
Central bank to play a direct role in financial supervision as during financial crisis, good policy-making needs a single ‘general’ in command.
Ensure that financial firms are not too big or too interconnected to fail else proper plans and the legal authority to deal with insolvent financial institutions should be in place.
Financial firms should have higher capital requirements and should primarily be equity-funded instead of being debt-funded.
Firms to disclose more information about their bets publicly on a daily basis so that traders are aware of systemic correlations in these bets.
Financial firm employees have a responsibility of not just maximizing shareholder wealth, but also control firm risk and protect integrity of the overall financial system.

Human sentiments play a major role in the volatility of financial markets and the two coming together would lend a sense of credibility that would even assuage negative sentiments in the entire economy.

Navigating the challenging Indian banking environment

The Indian banking sector, in the last decade, grew at an average of 18% compared to over 7% GDP growth. Thus, frauds pose a significant risk to institutions and capital markets as well. The effect can be widespread, thereby causing long term reputational and financial damage.

Figure 2: Factors contributing to fraud

Source: India banking fraud survey, 2012 by Deloitte

Lack of crackdown in fraud control creates a culture of acceptability within the organization, which leads to increased incidents in future. Implementation of appropriate controls and monitoring mechanism limits frauds and also sets the tone for ethical organizational behavior.

Figure 3: Areas prone to fraud

Source: India banking fraud survey, 2012 by Deloitte

The control mechanisms

The possible control failures throughout the banking process are shown below:

Figure 4: The control failures

Source: India banking fraud survey, 2012 by Deloitte

Banks can thus implement five key anti-fraud controls:

Top management to implement policies encouraging ethical behavior and demonstrating enhanced ethical culture.
Conduction of detailed fraud risk assessments involving various levels of management across all functions units.
Promote different tools for effective reporting of inappropriate or suspicious activities.
Drafting anti-fraud policy and providing periodic training throughout the organization.
The organization should have a documented policy of investigating and resolving fraud allegations.

Not just a “tempest in a teapot”

What determines how we behave? It is not so much our attitudes, education or personal values, but the underlying environment in which we find ourselves in. This influences our moves and behavior and so changing the underlying environment seems a plausible solution.

And what constitutes our underlying environment? A major part is comprised of the prevailing culture and values in which we operate and our organizations’ purposes, goals and objectives, as well as the monetary and non-monetary incentives. The pressures to conform to what our peers or rivals are doing - and the time pressures we are subjected to - are all important constituents of the environment.