Business

Coming to terms with new realities financial scene

— PHOTO: AFP

COVER FOR INSURER: Exterior of the offices of troubled insurer American International Group Inc.

On ‘black’ Sunday (September 14), the contours of the U.S. financial sector and to a large extent those of the global financial system changed for ever. That was the week-end Lehman Brothers collapsed and Merrill Lynch was taken over.

On Monday, the world’s stock markets went into a tailspin. Markets in China and a few other countries which remained closed that day followed suit on Tuesday.

Since then extreme volatility and nervousness have characterised the markets. The stock markets’ reactions are understandable and to an extent predictable but focussing on market behaviour can sideline certain other key issues.

On Tuesday (September 16), an even more sensational development took place. The giant insurer, American International Group (AIG), burdened by its problem exposures running into $441 billion, was already seeking emergency lines of credit. The U.S. authorities had not intervened when Lehman went bankrupt and Merrill decided to become part of Bank of America (BOA).

However, in a sudden reversal of policy, AIG was promised a standby line of credit up to $85 billion by the U.S. Federal Reserve in return for effectively handing over its control. Just three months earlier, Bear Stearns, an investment bank, was merged with JP Morgan Chase, with the U.S. Treasury aiding and abetting the deal. And, less than a month ago, the giant mortgage institutions Fannie Mae and Freddie Mac were virtually nationalised. Their financial position had become untenable.

These developments are momentous and have far reaching implications for the U.S. and the rest of the world. Unfortunately the end to the crisis is nowhere in sight. Nor does anyone seem to know where the next crisis will occur. There have been repercussions across the Atlantic, with Britain’s major mortgage provider HBOS coming under stress. Talks are on to merge it with Lloyds TSB group plc.

Last week, the mood was sombre everywhere. No one in authority was discounting the possibility of a domino effect knocking down even players who are far away from the action. For instance, the unwinding of Lehman’s huge positions in risky assets was not going to be smooth. Obviously many besides the counterparties will bear the brunt of the defaults.

With a systemic failure — collapse of the entire financial sector — staring them in their face central banks led by the U.S. Federal Reserve were mobilising huge funds to meet any contingencies. This is in addition to the considerable liquidity enhancement measures already under way.

Looking beyond these initial but highly significant regulatory steps, it is obvious that the financial world will have to adjust to the new realities.

Enhanced supervision as well as enlarged capital will be the pillars of the new order while many new lessons remain to be learnt. Recent developments will be reinterpreted in the light of fresh ones but even now there are plenty of long lasting messages.

The past week saw U.S. authorities adopting contrasting approaches to bank failures. By letting Lehman slip into bankruptcy, the Government seemed to be drawing a line.

Even Merrill’s takeover by BOA was not orchestrated by the Treasury. However, within 24 hours, the authorities performed a sharp U-turn and virtually took over AIG. Including Bear Stearns, four institutions have so far been rescued by the authorities. Substantial amounts of public money have been committed.

The reasons for the selectivity in official approach will be discussed for long. Evidently, in official reckoning, some institutions are too important to be allowed to fail. Others – even well known ones such as Lehman and Merrill Lynch – can fend for themselves.

The classic argument against officially sponsored bail outs of failed institutions is that such acts will encourage continued reckless behaviour that brought

them down in the first place. Other institutions may be tempted to take extraordinary and unacceptable risks if they gain the impression that their acts will somehow be underwritten and that they would never be allowed to fail.

What is called moral hazard arises when institutions and banks believe that they can make risky loans or investments and earn handsomely if their decisions turn out well but will not have to bear the losses if their bets are proved wrong.

The investment bankers, now in dire straits, drew handsome salaries and fat bonuses when the going was good. Many of them are now being shown the door. As for the institutions, even those that survive will have to operate under far greater supervision and submit to other restraints.

But the point is some of the institutions which took unacceptable risks have been saved, at least for now, with tax payers’ money.

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