Governance Deficit and Financial Crisis* G. Padmanabhan
It is always a pleasure to return to one’s home
state, that too if the state is God’s own country. Thank
you for inviting me to address this august gathering of
the cream of professionals and management experts
of the state under the common banner of Kerala
Management Association. I was, however, slightly
apprehensive of what I should talk at a gathering like
this. This apprehension started bordering worry when
I saw the list of illustrious speakers who have addressed
this forum in the past. We are living in interesting
times. These days, if any official from the financial
sector arrives on any forum like this, the audience
expects naturally to hear about the present status of
the global financial crisis that is yet to run its full course.
So I too chose to speak on this subject. But with so
much having been said and written about the crisis,
my dilemma was to select issues relevant to a group of
management professionals. To me the most virtuous
meaning of management is good governance. Good
governance more often than not, reduces the risks from
an uncertain environment around us. If one is to review
the events related to the financial crisis, what emerges
encompasses important management and governance
principles. These are also important lessons that we
perhaps need to keep in mind as the state discusses
the ‘Kerala 2030’ or ‘Emerging Kerala’ themes.
2. The Global Financial Crisis that began in 2008 has
caused large erosion in asset value, failure of financial
firms, contraction of output and slowdown in growth,
unemployment, and fiscal burden on countries, worldwide.
Even as the world was hesitatingly recovering
from the crisis through co-ordinated actions of
governments around the world, the sovereign debt
problem in the peripheral eurozone countries surfaced
and now threatens to derail the recovery and has the potential to plunge the world into a fresh crisis. Amidst
the sufferings brought on by the crisis, the only positive
feature is that it provides all of us with an opportunity
to draw the necessary lessons to be wiser and to put in
place institutional mechanisms that can avert the
possibility of a similar crisis in future. A crisis after all
is a laboratory for policymaking where the received
wisdom are put to test, old paradigms assessed and
new paradigms shaped. Thus, as has been said, a crisis
is not wasted if it leaves us wiser.
3. Post the Global Financial Crisis, policymakers,
regulators and academics have put their heads together
to mull on the fault lines that precipitated the crisis
and what remedial steps need to be taken. The
extensive reports from official institutions and
influential think-tanks as well as the legislative and
regulatory reforms that are in various stages of
conception and implementation in different
jurisdictions are well-known and it is not necessary for
me to repeat them here. What I intend to discuss is
something more fundamental – the issue of governance,
which provides the framework for all forms of human
organisations and infirmities which in turn can lead to
disastrous consequences. Specifically, analysis of recent
crises, as also of those fresh in memory such as the
Latin American crisis or the East Asian crisis, invariably
point to governance failures either at a macro level or
a micro level.
4. In a great deal of academic and policy discourse,
good governance has been generally linked to economic
growth and development. The growth and productivity
in developed nations have often been said to have had
their roots in institutions and legal systems of good
governance. And as a corollary, the lack of development
and crises of the emerging market countries have often
been ascribed to the prevalence of oligarchies, crony
capitalism, corruption and generally the absence of
good governance. Thus good governance has not only been advocated as a necessary condition for economic
development but for the developing countries, it has
been promoted as following the institutional practices
of the developed countries. But the crisis clearly shows
that even the rich developed countries, with their much
coveted institutions can have governance failures that
result in crisis of much graver proportion than the
failure of a corporation here or there, and bring on great
misery on their own people and to the rest of the world.
5. What is governance all about? The subject has
spawned reports, legislations and a large volume of
research papers. A google search on ‘corporate
governance’ yielded 33,700,000 results and Google
scholar, 8,99,000 articles! You will find complex legalsounding
definitions to mathematical equation ridden
research papers discussing corporate governance. But
what is the central idea behind corporate or any other
type of governance? I would put it in one word –
‘confidence’. Governance is about commanding
confidence of all those we do business with, all those
upon whom we depend. confidence that promises shall
be kept, contracts honoured and assurances delivered
upon. If your shareholders have confidence in you, they
will not be shy of putting money in your venture. If
you enjoy the confidence of your lenders, you will not
be starved of capital. If your employees have confidence
in you, you can attract talent and perhaps would not
face attrition. We can go on. What creates confidence,
then? If it is an individual, character evokes confidence.
If it is an organisation – a corporation, a state or even
an NGO – good governance is what creates, and sustains
that confidence.
6. If it is about creating and sustaining confidence,
we can list three cornerstones for confidence in the
edifice of good governance. First, there must be total
transparency. Information asymmetry is at the root of
all governance problems and therefore, access to
complete information for all stakeholders is a sine qua
non. If a company you have put your money in declares
a loss, you will be disappointed; but if it fudges its
account to mislead you into believing everything was
fine, you will surely lose your confidence in that
company when you discover the truth, as you ultimately
will. Second, the tension between temptation of immediate gain and long-term survival must be
resolved. Lastly, there must be a set of checks and
balances to achieve the first two. The salient features
of any good governance would therefore require certain
basic elements of checks and controls to be enshrined
and followed meticulously in the day-to-day functioning
of any financial firm or for that matter by any entity
which is answerable to a number of stakeholders. These
elements are not complex or esoteric by any stretch of
imagination. They are governed by, pure and simple
common sense, easy to understand, but require a good
bit of persuasion, perseverance and patience to be
followed meticulously. But often the sheer simplicity
of these principles makes the implementer question
their very need and dilutes the essence of
implementation.
Financial Crisis
7. Let me now turn to the recent crises, and recount
some of the most common and rather obvious elements
of governance that unfortunately have received scant
attention.
8. The seeds of the 2008 financial crisis were sown
by the easy and super-accommodative monetary policy
practiced by the US for a protracted period of time in
the early part of the last decade, which in conjunction
with certain other factors led to a desperate search for
yields and gave rise to the problem of adverse selection.
The adverse selection problem is nothing new in the
lending industry and is usually resolved by careful
screening and appraisal of the credit proposal. There
is possibly no financial firm in the world which does
not swear by tight lending standards in order to protect
the quality of its balance sheet assets. But this
elementary principle was given a systematic go-by by
the US mortgage lenders in pursuit of easy returns. It
is not that the lenders were unaware of the borrowers’
creditworthiness. Indeed, these loans were labelled
‘sub-prime’. All of you are aware of the onerous
documentation process that precedes a loan sanction.
The US mortgage industry had even devised a class of
loans called ‘Alt-A’ loans, where in disregard of all
norms of lending, the documentation requirement was
diluted. This aggravated the adverse selection problem,
because not having to produce any proof and documentation, the borrowers were inclined to
misrepresent or skew their incomes and assets to obtain
a larger loan than merited.
9. How could such a folly be committed? The entire
mortgage activity was based on the housing sector boom
and bubble in house prices. Rising house prices
appeared lucrative to the lenders and the borrowers
alike. Those rising house prices created positive home
equity for the early entrants who merrily drew upon
it, not for adding to the asset value but to indulge in
consumption expenditure as if the house property was
an ATM machine. But there have been bubbles in real
estate prices in US and elsewhere in the past which
ultimately burst. Neither the lenders nor the borrowers
reckoned that the housing boom of the early half of the
last decade could also end one day and behaved as if
there is only one way for the housing prices to go. This
reflects the triumph of obsession with immediate gains
and an utter disregard for long-run sustainability.
10. The problem was compounded by the fact that the
originators of the mortgages were taking them out of
their books and selling it to not gullible, but extremely
knowledgeable investors on the strength of ratings
accorded by the rating agencies. Now, take the case of
credit rating agencies. Any issuer of a debt instrument
cannot access the market without first obtaining a rating
from an agency. The rating is supposed to serve the
investor but is obtained and paid for by issuer. Is this
not a clear conflict of interest? What is there to prevent
an agency from issuing an unfairly favourable rating
against a suitable payment by the issuer? The argument
in favour of the arrangement traditionally has been
that the agency has considerable reputational capital
at stake and therefore would not sell pernicious ratings.
But this argument has limitations. Reputational risk
will act as a deterrent if the investors have some way
of punishing poor rating agency performance or if the
long-run downside due to loss of reputation outweighs
the short-term gains. Yet as the crisis has shown, there
was universal reliance on credit ratings without any
mechanism to address the associated infirmities. The
Reserve Bank has always been stressing the need for
due diligence and meticulous appraisal mechanisms
(even if ratings are available) for the banks. That the US mortgage investors were solely led by the ratings in
their investment decisions was a major reason for the
accumulation of toxic assets, which eventually paved
the way for crisis. The governance failure in this case
is nothing but the failure of simple due diligence
mechanism in asset book build up.
11. Credit Default Swaps (CDS) played a significant
role in proliferation of the crisis. CDS, in economic
essence, is an insurance against credit risk. The CDS
seller buys the credit risk of any single or pool of credit
instrument and compensates the CDS buyer for any
credit event that reduces the value of the instrument.
The beauty of the CDS market is that the protection
seller could be anybody. As you are aware, banks have
elaborate processes – pre-sanction screening and
appraisal, post sanction monitoring, documentation
etc. – to protect themselves against credit event. What
processes does a CDS seller have? The CDS is supposed
work on the actuarial principle. But what data goes into
computation of the actuarial table? Knowing that credit
events depend upon the business cycle, would it not
be necessary to exercise care if you are on the ascending
phase? Now, if a CDS has been bought for a credit
exposure to an entity, it is transformed to a credit
exposure on CDS seller and not the entity. If the CDS
seller happens to be an institution like the AIG, rated
AAA by an approved credit rating agency, there is little
residual credit risk on the books of the CDS buyer. This
frees the amount of capital held against potential losses
due to credit events, which can then be leveraged to
acquire more lucrative (and risky) assets-Ad infinitum.
The Federal Reserve, in 1996, permitted banks to use
CDS to reduce capital reserves. Following this decision,
the CDS market boomed and by 2007 the overall CDS
market reached a notional value of $ 62 trillion.
However, problem arises here because given the active
trading in CDS it was sometimes difficult to identify
the actual counterparty when the credit event occurs.
Also some counterparties like AIG developed massive
exposures to CDS which raised concerns about their
ability to meet their obligations in times of crisis.
12. The run up to the financial crisis saw a hey-day
for financial innovation that saw the creation and
exuberant trading of a large number of complex instruments supported by opaque institutions. The
transactions were mostly bilateral, over-the-counter
with no common knowledge of who is having how
much of which asset. All financial instruments bear
risk and when they are ripped and parceled into new
products. Hence, it is important to understand what
happens to the underlying risk and where it may be
residing at any time. Financial markets cannot function
unless participants know each other’s risk profile.
When complex instruments are traded in an opaque
market, the problem is further aggravated. Financial
distresses require regulatory intervention; the least
that the regulator needs to know to intervene effectively
is who is affected by how much. Yet, the crisis revealed
that not only the market participants had no knowledge
about their counterparty’s exposure to the toxic assets,
even the regulator did not! Fortuitously, The Depository
Trust & Clearing Corporation (DTCC) which had created
a platform for information on CDS for providing post
trade services to its reporting clients could provide the
information to the regulators and save the day.
13. The Dealing Rooms have been the epicenter of
several governance disasters across the world. Surprise
of surprises, this possibility has always been recognised
and the practices that govern the dealing room are
codified, audit-trailed and audited with unfailing
regularity. Yet they remain the most vulnerable to
deviations. It has been said that the small derivative
trading unit of AIG in London with just 400 employees,
virtually brought down this mammoth institution of
over 1,00,000 employees in 130 countries. Besides,
rogue dealers of financial institutions have virtually
ripped the balance sheets apart and yet, the senior
managers and the heads of treasuries pay only lip
service to the separation of front office from other
sequential functions, mandatory leave requirements,
broker limits for each dealers, and what not. Even in
the post-crisis period, when banks and institutions
would have been in a state of high alert, a rogue trader
brought on a 2.3 billion loss to UBS that cost the CEO
his job. If we sit back and analyse why these governance
systems fail, we will come across only a few major
issues: the perfunctory nature of compliance, an
incredible build-up of trust amongst individuals and
often, their activities. If the financial crisis of 2008 could spread its tentacles so easily across the world, the major
issue that crystallises is the impunity with which the
treasuries of even major financial institutions
functioned and the amazing level of complacency that
set in over a period of time.
14. This naturally leads me to the issue of
compensation. It has been alleged that the non-linear
compensation arrangements in vogue in most hedge
funds, merchant banks, and other asset managers,
where a fund manager’s rate of bonus increases with
the return he earns was a harbinger of the crisis because
it incentivised them to take on more risk. There was
an adage in the good old days that lawyers, bankers and
doctors should not be soliciting clients. There is a lot
of sense in it, because of the perverse social incentives
such an arrangement would create. The blogosphere is
full of dismay and consternation at the exponential
rise in the share of financial sector and the outsised
compensations. There is also a view that imposition of
restrictions on compensation may have unintended
consequences such as migration of financial activities
to offshore centers. While the issue is unresolved, the
adverse incentives and long run implications of
compensation packages need to be kept in view.
15. Another fertile ground for the governance failure
has been the complex and sometimes, creative
accounting practices employed to hide simple
misdemeanors. Financial reporting is at the heart of
corporate governance – It is the most important
communication between the corporation and its
stakeholders. Yet, errant corporations have used, often
with active support of auditors and accountants, various
stratagems to misrepresent the actual financial
condition of the company, thus stalling the stakeholders
from taking timely action. Maxwell Communications
in UK and Enron in US are cases in point. The Satyam
debacle back home is a classic case where an individualcentric
top management could hide its misdemeanors
for an extended period of time, taking a few audit firms
as their accomplices paying a suitable price to buy their
honesty.
The European Debt Problem
16. No discussion of crises or governance today can
exclude the sovereign debt problem of the peripheral Eurozone countries. If we take a careful look at the
present sovereign debt crisis roiling the Eurozone, it
should not take us too long to realise that this crisis
also owes its origins to governance failures. The only
point of difference between this and the 2008 crisis is
that the entities which are at the root of the present
crisis are Sovereign Governments and not the usual
suspects which are ‘profi t-seeking’ corporations. How
did Greece manage to get into the Eurozone? Was there
any fudging of figures? How did the others permit this?
Again, there was a clear element of acquiescence on
the part of core euro members to enlarge the circle of
Eurozone at the cost of non-compliance with the tenets
of Maastricht Treaty. How did the crisis surface? By
admission of the Greek Government that the fiscal
statistics it had earlier presented may not be true and
the true position could be significantly worse.
17. The European debt crisis has prompted an
interesting discussion on governance and sovereign
debt. There seems to be interplay between governance
performance and the debt level. Better governed
countries can afford higher levels of debt. Conversely,
badly governed countries can tolerate only lower levels
of debt. This hypothesis also helps to partly explain
the ostensible paradox of why countries with higher
debt levels can carry the burden and why countries
with lower debt levels may face a market reluctant to
invest in its liability.
18. This view seems to suggest that mere financial
and economic measures may not be sufficient to
address the problems countries like Greece face, if not
accompanied by governance reforms. This is also why
even after the Greek parliament passed the austerity
measures as a precondition for further assistance, the
market is reluctant to accept it as a watershed and
displays a great deal of skepticism.
Governance and Regulations
19. Regulations are a necessary adjunct to corporate
governance. The processes associated with corporate
governance are internal to the organisation. Regulations
are designed to serve the same end, but are external to
the organisation and seek to provide a nudge to enforce
the governance process. While regulation of nonfinancial firms is structured around the basic themes of disclosure, investor protection and management of
bankruptcy, regulation of financial institutions,
particularly banks, are usually much more stringent
because of the grave consequences of their failure. Prior
to the onset of the crisis, there was a critical intolerance
for regulation by the proponents of market-based
economic systems. This was reflected in the lax
regulatory framework governing the financial markets
and institutions. It is now widely acknowledged that,
weak regulations were responsible for the sub-prime
crisis and efforts are under way to make regulations
and supervision more comprehensive and robust.
20. Merely having a strong regulatory and supervisory
framework is not enough. It is also equally important
as to how the rules and regulations are enforced.
Manipulation of the due process by incumbent
oligarchs or crony capitalists to their advantage has
been a recurrent theme in the context of developing or
emerging market economies. But the financial crisis has
shown that this can happen even in the US. It is well
known that the five major investment banks – Goldman
Sachs, Lehman Brothers, Merrill Lynch, Bear Sterns and
Morgan Stanley – commanded tremendous clout with
the policymakers, but they are also suspected of
tweaking the regulatory apparatus to their advantage.
As reported in New York Times, these five ‘big guys’- led
by Hank Paulson Jr of Goldman Sachs, who would take
over as the Treasury Secretary two years later – met the
five commissioners of the SEC in the afternoon of April
28, 2004 in the basement hearing room of the Securities
and Exchange Commission (SEC) office in New York to
discuss the issue of freeing of capital from their
brokerage arms that could be leveraged to buy even
more complex instruments. After 55 minutes of
discussions the demand was acceded to. As Dani
Kaufmann laments, it is a case of ‘legal corruption’. No
bribe has been paid, no laws broken, yet the effect is
the same.
An Indian Perspective
21. Now, let us look at the Indian perspective. The
Indian financial sector may not be as sophisticated as
those of the developed countries. There are barriers to
entry to several market segments imposed by the
compulsions of capital account restrictions. The range of products is narrow and their liquidity limited. Our
approach to further development of the markets is
marked by cautious gradualism. But as far as governance
and regulation are concerned, we can perhaps boast of
a resilient system alive to the potential problems we
have discussed. Let me recount some of the measures
that we have taken in support.
a. With a view to promoting transparency in the
over-the-counter (OTC) derivatives market, we had
mandated, as early as in 2007, a transaction based
reporting system for the only active class of
interest rate derivatives, the interest rate swaps
and dissemination of information based on such
reporting. We are in the process of taking the
initiative further by extending the reporting
requirements to all foreign exchange and interest
rate derivatives.
b. To ensure that there is no laxity in credit appraisal
in case of securitisation, we have mandated that
the originator of a loan asset has to hold it in its
books for at least one year before securitisation
and that he has to retain the equity tranche of the
securities created.
c. We have introduced not only anonymous, order
matching trading system for trading in government
securities to improve transparency, we have also
introduced central counterparty based guaranteed
settlement for government securities and foreign
exchange transactions.
d. We have stipulated that ratings of external
agencies can complement and not substitute the
internal appraisal processes for sanction of loans
by banks.
e. Introduction of credit default swaps has been
subjected to purchase of protection only by the
holders of the reference obligation and sale only
by regulated entities.
f. As early as 2005, we have used risk weights and
provisioning norms for influencing the flow of
funds to the housing sector and moderating
excessive growth.
Conclusion
22. In conclusion, let me summarise what we have
discussed. Good governance is a necessary condition
for not only economic growth and development but for
an easy and comfortable society where we can go about
our business – confident and unruffled. Good
governance is of utmost importance for the financial
sector but needs to be complemented by alert and
efficacious regulation and supervision so as to build
and maintain confidence of the savers and the
investors. We, as a nation, have begun our journey and
the tryst with our destiny and we need continued
confidence of all our stakeholders to reach our
destination. Our responsibility towards good governance
cannot be overemphasised. In this endeavour needless
to mention that members of this august audience are
the principal actors.
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