Lately, there has been a lot of buzz around how Reserve Bank of India, Bank of China and other banking industry regulators in the emerging world saved their respective economies from the recent Great Recession. According to the subtext, these conservative agencies acted in time to pass regulations which prevented their banks from engaging in the sort of extremely risky shenanigans that almost brought the roof down on developed economies.
Since I haven’t yet forgotten statements made not so long back by many Indian IT moghuls that India could become a software powerhouse only because it was free of government intervention (read regulation), I now find it hard to come to terms with the diametrically opposed notion that credits regulators for ensuring the well-being of an industry!
Let’s look at the root cause of the recent recession that struck developed countries and analyze what was really different in India and other developing nations that kept them insulated from it.
To do this, let’s draw an analogy with the risks and rewards of high-sea fishing. Let’s think of subprime mortgages, mortgage based securities (MBS), collateralized debt obligations (CDO), credit default swaps (CDS) and other financial products as the fish swimming in the sea that is the financial services industry.
For several years before the subprime mortgage crisis struck the developed world, Wall Street and London City bankers were fishermen who reaped a rich harvest from these seas.
(For those having any doubts about the rich harvest bit, let me simply explain “4 x 4”, a fairly standard pay package for investment bankers in middle management in London during 2004-2007: The first “4” stood for a fixed salary of GBP 400,000 per annum and the second “4” meant a guaranteed bonus of GBP 4 Million a year).
In the end, as we all know, the fish proved to be sharks that nearly gobbled up the fishermen and the sea.
According to the popular notion, regulators in emerging markets always knew that the fish were sharks and posted warning signs on the shore to this effect, whereas those in the developed world were asleep at their watch.
Nothing could be farther from the truth.
The fact is, financial services industries in emerging markets weren’t as advanced as those in developed nations – at least not when the recession struck in 2007-08. They didn’t have MBS, CDO, CDS, and other sophisticated financial products. For them, it was like no fish or sharks, so no one got gobbled up, so no question of crisis. Period.
As and when structured financial products are launched in emerging nations, should we be worried that the sharks would migrate to their seas? Not necessarily. Although their regulators are not clairvoyant, they have the benefit of learning from others’ mistakes. By banning third-party CDS contracts – which is one factor that allegedly precipitated the Great Recession in the developed world by triggering off some of the worst abuses by their financial markets – India’s RBI has shown its ability to develop hindsight that is proverbially 20/20.
While regulation didn’t avert the last crisis, it can play a strong role in preventing an identical one from striking emerging markets in the future.