Defaults and stresses are being witnessed across banks, mutual funds, non-banking financial companies (NBFCs), the bond market, and real estate.
It is high time that the government understands the importance of system approach than the current micro-prudential regulation.
How does micro-prudential regulation work?
Micro-prudential regulation is the job of pushing financial firms to cap their failure probability.
It involves writing rules that prevent excessive risk taking by banks.
E.g. there may be an objective that no more than 2% of banks should fail per decade
It ensures that the failure probability of any one bank does not exceed 2% over a 10-year horizon.
With mutual funds, there is no possibility of firm failure.
So SEBI's concern in micro-prudential regulation is to ensure that net asset value (NAV) is always reported correctly and promises of redemption are always met.
To achieve the objectives, micro-prudential regulation thinks deeply about one financial firm at a time.
It identifies a minimal set of interventions which achieve its narrow objective.
However, this approach avoids central planning of products and processes.
How did the recent crisis evolve?
Credit stress in non-financial firms (e.g. infrastructure and real estate) surfaced in 2008.
Early bankruptcy solves the problem, but when this is not done, the amount of debt increases significantly.
With stressed borrowers, new debt is required to pay off old debt.
The balance sheet grows, as default is staved off by paying old lenders using money borrowed from new lenders.
For many years, weak borrowers were given more debt by banks.
When the banks got conscious about their over-leveraging, at first, a new funding channel was opened up.
Thereby, the mutual funds, NBFCs and the bond market came in.
But these too have run into difficulties in the last one year.
Now India has a group of stressed borrowers running out of ways to recover, and four stressed components of the financial system.
The problems of borrowers, real estate prices, bond market, mutual funds, NBFCs and banks are reinforcing each other now.
What lies ahead?
The components of the recent problems are not to be seen in isolation.
It is difficult for a fragmented financial regulatory architecture to obtain information, make root cause analysis, and solve problems.
Also, there is a natural bias for micro-prudential regulators to postpone the recognition of a problem.
What is needed is a system thinking that diverges from the view of one firm at a time i.e. micro-prudential regulation.
There is a need to see the financial system from a high-level perspective, and see the pressures and relationships.
Such an approach could significantly acknowledge the interconnections among the shortfalls and address the problem in a better way.
An informal team that looks into the various components of the financial system holistically may work.
