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Wealth of nations

Post G-20, the regulation of financial markets will become dynamic. Dipankar Bhattacharyya elaborates.

india Updated: Apr 07, 2009 20:52 IST
Dipankar Bhattacharyya
Dipankar Bhattacharyya
Hindustan Times

The G-20 summit in London last week invited its share of approval and scorn. The former was mostly self-inflicted, the latter spread wider — from riots in The City’s streets to tut-tutting in its ivory towers. The main criticism is whether the 20 leaders, who among them control 90 per cent of the world’s economy, are doing enough to take it out of its worst crisis since the Great Crash of 1929.

Apart from reaching deeper into their pockets, or at least promising to, the G-20 is also looking at ways to save capitalism from itself. Here, away from the photo-op, a working group on the regulation of markets has come up with a couple of interesting ideas. These have been presented to policymakers — central bankers and finance ministers who will eventually have to draw up oversight regimes that ought to prevent the recurrence of the Great Crash of 2008.

The departures from the current orthodoxy on containing risk try to address market behaviour as opposed to individual behaviour and its variation over a business cycle. Essentially, the market (in this case the financial market) is greater than the sum of its parts and its appetite for risk varies over time. What the G-20 working group suggests is that alongside rules for individual agents that most economies have in place, they should have rules for the market overall, and these rules should be scalable as the situation demands.

If every student wants to sit in the back to avoid the gaze of a daunting teacher, the class is hollow at the front. The teacher then has to ask some of the students to come on up to the front row. The group consequences of isolated behaviour get addressed in classrooms, but not in the outside world. This is where the G-20 is arguing for macro-regulation as a supplement to everyday micro-regulation.

“The impact of the collective behaviour of economic agents on aggregate risk needs to be taken into account explicitly,” the paper states. “It may be individually appropriate for banks to take more risk during benign economic times, for example by increasing lending. However, when this behaviour is widespread, the overall leverage of the banking sector may create the potential for financial instability. Micro-prudential and macro-prudential authorities may view this situation differently. The increased leverage may not be viewed as a concern from a micro-prudential perspective if it is supported by appropriate safeguards at the institution level, for example by sufficient capital buffers. However, even if these safeguards are considered appropriate for an individual institution, a macro-prudential regulator may nonetheless be concerned by the potential for a systemic imbalance arising from a widespread increase in the overall leverage of the banking sector.”

In short, don’t look only for the weirdos, check if the system is acting weird as well.

Getting back to the classroom. If the next teacher is not as intimidating, the class may well not be bunched up at the back. This teacher will not feel the need to call anyone to sit in the front row. Likewise, the market’s appetite for risk swings wildly between boom and bust and the G-20 is arguing for tighter reins when the animal spirits are high.

“Certain aspects of accounting frameworks and capital regulation increase the natural tendency of the financial system to amplify business cycles. This tendency is particularly disruptive and apparent during an economic downturn or when the financial system is facing strains. There is a lack of incentives for the financial system to lean against rapid growth of credit and asset values during benign economic conditions. This would not only mitigate the build-up of imbalances that give rise to systemic risk but, by building up prudential buffers during the benign phase of an economic cycle, when it is easier and cheaper to do so, institutions would enter more challenging times from a stronger position.”

Again, one set of rules for fear, another for greed.

The G-20 working group has recommended the financial regulators in each country should, as a supplement to their core mandate, take account of financial system stability. The Financial Stability Forum and the Basle Committee of Banking Supervision, on each of which India finds a seat, are required to develop approaches to mitigate pro-cyclical regulation.

First Published: Apr 07, 2009 20:51 IST