S. VENKITARAMANAN

The Fed's willingness to urge banks to lend to market intermediaries helped rescue the US stock market from its margin-related crisis.

The stock market saw a rapid rise and an equally spectacular fall in the last few months. Policy-makers first cheered the rise as evidence of the economy's strength. When the fall came, the usual suspects were hauled up, including foreign institutional investors, global stock market falls and, strangest of all, a draft circular of the Ministry of Finance, purporting to withdraw some tax concessions for financial institutional investors. The Finance Minister, Mr P. Chidambaram, was quick to reply to the charges and carried the offensive to the enemy's camp, saying the whole case was manufactured. He dismissed apprehensions of the draft tax changes as baseless.

That the draft change would have put FIIs in a somewhat invidious position is obvious. The treatment of FIIs as traders or as investors introduced a material change in the tax burden. At the minimum, it was extremely inappropriate to hint at such a suggested change, considering that it would create ambiguity where there was clarity before. Anyway, the FIIs apparently reacted by pulling out in hordes.

The Finance Minister's exhortations to domestic mutual funds to fill the gap reminded us of the bygone days of "directed" investing. Mr Chidambaram also "talked" up the market, saying investors should stay invested. Whether or not investors listened is not quite clear, although the market seems to have regained some of its spring.

Greater volatility

The rise and fall of the Sensex is not an earthshaking event. Prime Ministers have stated that they do not lose sleep over the movement of the BSE Sensitive Index. The Finance Minister is also on record as stating that he does not watch the Sensex every hour. Obviously, he has other and weightier things to do. But, to the retail investor whose eyes are glued to the TV screen, watching how the markets move the Sensex often means life or death. He or she is materially interested in what caused the mayhem. On that rests his fortune.

It is important to note that we seem to have been subjected to greater volatility than many other countries, except oil-driven economies like Russia. The Table compares the experience of similar indices in other countries.

The data in shows that, while there has been volatility in most economies, the developed economies have shown less of it. India has fared worse than Hong Kong, Singapore and Taiwan. We are more at the level of volatility of Brazil, Mexico and Russia. In general, the developed economies have escaped the full fury of the latest market mayhem.

An interesting comment concerns the provision of bank finance against margin calls. It has been alleged that part of the problem arose because banks were not so forthcoming with margin finance, which investors need to borrow against their shares. When markets fall, margin calls are also inevitable. The question is whether our banks were reluctant to lend. Were banks not clear about what they should do?

Banks' reaction

An argument has been advanced by a knowledgeable economist that the RBI is yet to send a circular clarifying the latest edition of its Credit Policy (lending for the capital market to be 8 per cent of net asset value, or 10 per cent of net worth). The argument is that banks did not lend because the regulator had, in effect, told them not to. The extra caution among bankers is natural, given their prior experience in volatile markets. But hesitancy in lending against stocks is a sure recipe for increased volatility, as the failure to finance for margin calls speeds sell-offs and fuels a further decline.

On reading of this alleged "failure" on the part of the banking system, my thoughts went to another time and another place. I refer to the classic reaction of the US Federal Reserve's then newly anointed Chairman, Mr Alan Greenspan, and his deputy, Mr Gerald Corrigan, to the market crash of 1987 — a Black Monday in October 1987.

Chairman Greenspan heard the news as he was landing in Dallas, Texas to deliver an address to the American Bankers' Association. The market had crashed by 22.6 per cent. It was a more precipitous fall than that which had occasioned the Great Depression of the century. The Fed Chairman was stunned and he reacted boldly.

He looked at the situation as a case of restoring the "plumbing" system of the financial structure. Mr Corrigan was personally on the phone to every major banker in New York and elsewhere to loosen the purse strings and to fund the broker intermediaries whose margin burdens were becoming unsustainable.

The Fed experience

The Fed also released adequate liquidity to the nation's banking system to rescue the stock market intermediaries from their margin-provoked crisis.

Liquidity was the key and the willingness of the Fed to urge banks to lend to market intermediaries was the tool for revival. The Greenspan rescue of the stock market in 1987 has, indeed, become part of central banking legend.

The White House was also closely involved, on an hour-to-hour basis, with the resolution of the 1987 crisis. The Chief of Staff of President Reagan was in hourly contact with Mr Greenspan.

The President even offered to send the Presidential aircraft to fetch Mr Greenspan to Washington without waiting for the scheduled flight, if need be. Mr Greenspan managed the crisis with full consciousness of the role that additional liquidity plays in such a market crisis.

Significantly, the then Chief Executive of the United States of America, President Ronald Reagan, himself, felt it necessary to keep a watchful eye on the market. Not for him the stance of benign neglect, a characteristic of other less mature economies!

More responsive

While it is not the purpose of this article to point accusing fingers at our central bank, which is doing its best, it is necessary to highlight the need for central bankers to become more aware of the close inter-relationship between banks and the market.

There is need to stress-test our banks, particularly the payment systems, for the speed and accuracy with which they react to a market crisis, such as the one that occurred in May 2006.

Measures to make the banking system more quickly responsive and positively sensitive to the needs of stressed market intermediaries are absolutely necessary.

An in-house study of what happened and what can be done to ensure greater responsiveness to market volatility may be well worth the while. The RBI Governor, Dr Y. V. Reddy, has always been prompt in responding with positive solutions to perceived and real problems.

The recent market crisis would have rendered a signal service to the modernisation of India's financial system, if it triggers a healthy marriage of banks with the reality of the modern stock market, subject as they are to fickle flows of off-shore funds and sensitive to global economic developments even more than local ones.

A stress-tested mechanism for keeping the financial plumbing system healthy, responsive and clean is the need of the hour, if we are to mitigate the margin-fed vicious cycle of volatility.

The RBI needs to examine and set in position the suitable machinery to handle these objectives. That is the abiding lesson of the Manic Monday of May 2006.

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