International Finance in Days of Turbulence

Over the past couple of years the doomsayers of capitalism have won the day more often than not. First came the
dotcom bust, which put a stop to what is now called Irrational Exuberance. Then the awful 11th September event
proved beyond a doubt that terrorism has come of age. Finally Enronitis struck America. What followed was
possibly the worst crisis of corporate credibility, which saw the fall of once mighty giants like Anderson, WorldCom,
Kmart and not to say energy-to-finance-to-fraud conglomerate Enron.
As stock markets tumbled the world over, total global marketable wealththat is, the value of all assets traded in
the financial markets, such as shares and bondsfell by 4% last year, according to a study by the Boston
Consulting Group. Surprisingly the financial sector emerged relatively unscathed. A nationwide plunge in personal
wealth, the domino effect of corporate crises due to bankruptcies and an unexpected decline in profit, all these
factors constitute a sure recipe for banking failures. However fortune smiled in the face of adversity this time and
saved the day. Consumers remained confident and carried on spending, keeping both the economy and the
financial system stronger.
After the September 11 terrorist attack, the Fed played its role to perfection. It allowed unlimited lending, and
suspended normal prudential requirements for banks to set aside capital against loans. Banks increased their
lending to provide short-term finance for companies suddenly deprived of access to the commercial-paper market.
Had the market started to fear some payments would not be cleared, the resulting panic could easily have taken
down one or more big global banks and many of their clients as well. The regulators bade good-bye to rules for a
while, as the Fed took great credit risk to ensure that panic didnt set in.
The past decade has seen a process of major churning in the financial sector in America and the rich European
countries. Industry leaders today are no longer just banks but financial services companies. A decade ago broad
based European continental companies were financial market leaders whereas American ones had to make a
choice between corporate banking, investment banking and insurance. The scrapping of the Glass-Steagall Act has
led to the emergence of multinational financial service giants like Citigroup, J P Morgan Chase etc. with
astronomically high figures of market capitalization. A fatter balance sheet makes it easier for companies to absorb
extraordinary amounts of losses. Organic growth and growth through M&A activities has acted as a shield against
local crises by providing benefits of diversification. The bigger organizations of today have managed to minimize
their credit risk by geographically diversified and balanced exposure in various sectors.
Diversification doesnt absolve lenders from being prudent in their credit decisions. Generous credits issued to
Enron, Argentina and Xerox are likely to haunt them for good. And trends show a disturbing tendency on part of
commercial banks to ensure business for their high profit Investment Banking wings by allowing easy credit to
prospective clients. The increased focus of financial giants on their Investment Banking wing has subjected the
specialised investment banks like Goldman Sachs and Morgan Stanley to severe competition. The margins on
institutional brokerage have been declining by 5% a year. The collapse of IPO underwriting and shrinkage in M&A
activities has taken out two of the few remaining areas of business. The fight for a shrinking pie may result in further
consolidation in the financial sector. From a pool of 20-25 banks a year ago there now remain a dozen.
The consolidation in the banking sector may well end up increasing the riskiness of the financial system. Typically
highly liquid markets like US Treasuries and foreign exchange are beginning to face abnormal liquidity crunches.
The reason may be explained by the fact that liquidity is a function of not only the size of the market but also the
diversity of opinion of those trading in the market. The less they disagree the less liquidity there will be. Nowadays,
due to the speed of information transfer the scope of disagreement arising out of information asymmetry is very
limited. Since all the big firms use more or less the same kinds of internal risk management systems, more often
than not they move as a herd, creating liquidity problems. One way to sort out this problem of increased
homogeneity of opinion would be for institutional investors with different investment horizons to become providers of
liquidity. Then again, not everyone has both the acumen and the resources to go against the grain. Some insurers
have started taking risks that the Banking System no longer wants. Though this breeds diversity, it is not without a
downside. Very few insurance companies are as well informed and sophisticated at managing risk as banks. So
much of the risk may actually end up in the hands of less sophisticated investors who may be taking on the risk
unwittingly not fully understanding the consequences of the same.
Much of the dynamism today in global finance is due to fewer regulations, which allows the free flow of money
across borders. This has done more good than heavy regulation. Leaving capital, free to find its own high return

opportunities has exposed the over-costly or misplaced regulation, the money has simply gone elsewhere. In
general, competition for capital has forced nations to improve their regulations to attract mobile capital flows, and
has not led to a race to the bottom. Internationally mobile capital has tended to reward regulation that protects
investors and minimises privileges for market insiders.
However, understanding whether the level of risk is getting too high has become harder now that so much risk is
being transferred out of the banking system. Regulators and financial firms alike are better at judging the relative
riskiness of different instruments, institutions and counterparties than the total risk in the system. Banks have also
discovered ways to use derivatives and other securities to allow relatively risky loans to qualify for a low-risk, lowcapital treatment. Regulators fear that a large part of the growth in the use of derivatives and securitisation by banks
may stem from evasion of regulatory controls. In this context, a market-based system of regulation has begun to
receive some attention. If banks issue short-term subordinated debt that is traded every day and has to be
refinanced regularly, and can stay in business only as long as the debt is refinanced, then the market will in effect
regulate the bank. Lenders will not finance a bank they think is in risk of default. As a result, regulators would
increasingly have to rely on the private sector to assist them in their regulatory task. The rationale behind this is that
regulators simply do not have the capacity to find out what risks are being taken inside a large international bank
unless it tells them. All this suggests that, just as market failures are an inescapable feature of free-market
capitalism, so too may be regulatory failures by its watchdogs. The first line of regulation should involve those
whose money is at risk viz. the banks. However, banks as well as other capital market participants have proved to
be singularly reckless in the face of the sort of financial bubbles which regulators had vanished forever.
In an efficient market system, prices factor in all relevant information and reflect fundamental values and there is no
chance for financial bubble. Nowadays, efficient markets have become such an article of faith that if a price goes to
a level for which there is no obvious economic explanation, the believer simply concludes that there is a nonobvious economic explanationsuch as the coming of a more productive new economy. What is not concluded is
that there may be a bubble.
A growing number of economists have turned against efficient-market theory, at least in its extreme no bubbles
version. One weakness in the theory is its assumption that arbitrage by the informed against the uninformed is
riskless and costless. Perhaps the most famous example of the cost of arbitrage becoming unbearable was the
collapse of Long-Term Capital Management in September 1998. LTCM was betting on the prices of various
securities moving closer together, because it believed the true value of different pairs of securities was the same.
However, when the prices first diverged, the net market value of those positions dropped so much that some of the
counterparties of LTCM trades feared it would go bust. They therefore required ever more collateral or became
reluctant to do business with LTCM at all. In the end the Federal Reserve had to organise a rescue by several big
banks. Recent studies also illustrate the limits to arbitrage. With many of the dotcom companies, the authors point
out, the number of shares in circulation was very small. There were not enough available to borrow to meet the
demand from would-be shorters. Given that in practice the scope for arbitrage is limited, it is quite possible for
people with inaccurate valuations to set prices, and for these prices to get way out of line.
A growing number of economists have become adherents of behavioural finance, which attempts to explain realworld deviations from the asset prices predicted by modern finance using the insights of human psychology. The art
of valuing shares may be getting harder because of changes in the nature of the economy. When the bulk of a
company's assets were physical and its markets were relatively stable, valuation was more straightforward. Now a
growing proportion of a firm's assetsbrands, ideas, human capitalare intangible and often hard to identify, let
alone value.
Moreover, some argue that bubbles are not so bad. They tend to coincide with periods of innovation that make
society better off. The Internet, may have cost investors a fortune, but it has been a boon for its users. Policies that
would be effective for preventing or pricking bubbles might also kill the underlying innovation.
All this brings us to the fundamental question, IS GREED GOOD? The 1990s seem to have given rise to a
symbiotic relationship between Wall Street and company bosses arising out of a common greed. The concept of
share options to a great extent solved the problem of managers interests not being in line with that of shareholder.
What the theory did not allow for was that share prices could deviate substantially from their fundamental value, and
that management could help this process along in the short term. The short term might be long enough for them to
exercise their share options and sell the shares before the market caught on.

Such stock options also happened to encourage behaviour that was good for Wall Street. Earlier, managers often
put up fierce resistance to their firm being bought, because they might well lose their jobs. But because the options
vest the moment a firm changes hands, they can make a takeover positively welcome to managers. That suits
investment banks, which are constantly encouraging mergers and acquisitions because of the huge fees they
generatenotwithstanding the lamentable economic record of most mergers. The managers at the firm that does
the buying do not benefit from vesting options, but they are routinely offered another carrot: a huge bonus for pulling
off the deal.
It may not be necessary to stop using share options. However, they do provide an incentive to boost the share price
in the short run, which may not be in the company's best long-term interest. One way to remedy that is to prevent
the manager from selling the shares until some time after he has left the company, say three years. That is a long
enough period for any trickery done on his watch to come to light. This need not do much damage to the manager's
finances; a bank would be happy to extend a loan secured against the locked-up shares, if it did not think they were
artificially overvalued.
Another public enemy is the Wall Street research analyst. Analysts are supposedly another force for good corporate
governance, since they provide investors with independent analysis of a firm's accounts and prospects. In practice,
it seems, they often simply touted shares on behalf of the investment bank that employed them. This was
particularly true of shares sold in IPOs. Investment banks earned huge sums of money from underwriting IPOs, and
from other business relationships with companies. They typically earned little or nothing from selling research. No
wonder the researchers often bowed to the investment bankers' demand for a buy recommendation to keep client
firms happy.
The potential for such tainted research was greatest in the technology, telecoms and financial-services industries,
which contributed the lion's share of investment-banking revenues. Investment banks are now writing new rules
supposed to ensure the independence of their research, or at least give that impression. One remains a bit skeptical
of this, because independent research firms have so far struggled to earn large revenues. Perhaps nobody really
believes that having good research will help them make money in the stockmarket.
Adapted from The Economist
by Mansharan Kaur, Ritwik Ghosh, Ganga Pratap and Kanishka Ghoshal.