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Guiding markets from crisis to calm needs confidence, coordination and capital

Akhilesh Tilotia
Great Financial Crisis, non-banking finance companies, European Central Bank, financial markets, IL&FS, Reserve Bank of India, TARP, sebi

When commemorating anniversaries, we tend to reserve our special attention for round-number, decadal years. Last year, around this time, the world-and India-remembered and recounted its lessons from the Great Financial Crisis (GFC) that reverberated across the globe in September 2008. Since it is the nature of history to repeat, but not to rhyme, decadal recounting of experiences and learnings serve as good markers, but may not be timed to perfection.
The challenges in the local banking and non-banking finance companies 11 years post the GFC require us to take a relook at the learnings, especially, on the aspects that eventually led to the calming of the markets. India is nowhere near the situation that the world witnessed 11 years ago-however, GFC offers helpful pointers on how to navigate the sometimes choppy waters.

The business of finance is built on the edifice of trust and stability-witness the large, stately, grand, stone buildings of the banks of yore. Whenever a challenge strikes the financial markets, there is a need to calm the markets to restore trust and rebuild stability. The path from crisis to calm requires confidence, coordination and capital.
Confidence

Almost always the trigger for a dislocation in the financial markets is breakdown of trust. Restoring trust requires building confidence. This can happen either (a) by using the 'last resort' powers of the regulators and the government, or (b) by limiting the trust deficit to the entities which are in trouble in reality and not just in perception.

The most famous example of engendering confidence in the financial markets remains that of Mario Draghi, the then-president of the European Central Bank (ECB), who in July 2012 said, "Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough". This boosted the confidence of market participants not just in the European Union, but across the world.

On the (yet another!) anniversary of the news of defaults at IL&FS, the financial system in India is being buffeted by news of stress in non-banking finance companies and cooperative banks. Reserve Bank of India has assured depositors-timely and forcefully-that the banking system is safe. Hopefully, no further news-flow disturbs the trust that links the financial markets together. However, if such a situation were to come to pass, the authorities should be willing to build confidence by "doing whatever it takes". Sometimes an asset quality review can also help restore trust by identifying and isolating problem areas, allowing the market to function normally for the remaining participants.
Coordination

The US government put together the Troubled Assets Relief Program (TARP), a $700 billion fund in October 2008 to purchase toxic assets from financial institutions. The Federal Reserve cut rates dramatically, and also started a quantitative easing programme of an unprecedented magnitude. Meetings of central bank governors, and of G20 leaders and finance ministers helped create forums for global coordination. The intent of such coordination was to restore the trust in the financial sector and avoid the impact of the Wall Street spilling on to the Main Street.

The Indian authorities have taken cognisance of the economic slowdown and have been responding with cuts, both in tax and interest rates. The coordination of the monetary and fiscal authorities in reviving investment via these cuts should yield results. However, the economic slowdown and tax rate cuts could cast a shadow on the fiscal glide path (and a consequent impact on inflation) making the coordination with monetary authorities more difficult. The ministry of finance and RBI could announce a medium-term coordination framework which works in this new environment. Since challenges span a large number of regulated sectors, various regulators like ministry of company affairs, Reserve Bank of India, Real Estate Regulatory Authority, Securities and Exchange Board of India, various investigative agencies, etc may need to coordinate their actions so as not to spook the confidence.
Capital

Warren Buffett invested $5 billion in Goldman Sachs at the peak of the crisis in September 2008. This came soon after many investment banks shut shop, triggering domino effects of unravelling credit links globally.

Any financial dislocation requires capital to come in from 'strong' hands to give confidence to the 'weak' entities. Speculative activity which bets on survival or demise of an entity can significantly abate, if such an entity is seen to be backed by strong shareholders who have the ability to outlast a speculative phase. Takeover of certain types of financial institutions may be constrained by shareholding restrictions for financial institutions. Regulatory provisions, which allow regulators to create a caveat for concentrated holdings for some time, can offer opportunities for large private equity funds or strategic investors to commit capital to troubled financial institutions, thereby restoring trust.

Resolution

It is important to recognise that 'resolution' cannot be imposed using policy actions. Actions can be taken to diffuse challenges and rebuild trust, but resolution requires the varied market participants to find their own equilibrium. The process of finding a new equilibrium can be long-drawn: it may be guided by the 3Cs, but cannot be hurried.

Author of The Making of India

Views are personal