Is there any stable cause and effect relationship in financial markets? Can the effect of certain economic developments, or regulatory actions on financial markets be predicted with a reasonable degree of accuracy? Perhaps the majority of market analysts would answer in the negative. The reasons are simple. For one, fashions change and numbers on which market participants focus keep changing with them. To quote a recent example from currency markets, look at the yen: dollar rate. For a couple of years, the driving force was interest differentials. Last month it shifted to the impact of the cheap yen on politically sensitive trade numbers "" and the exchange rate moved about 15 yen in less than a couple of weeks.
For another, events affect expectations and the latter, in turn, affect events "" a phenomenon George Soros described as reflexivity. It is a continuous process in which it is often impossible to draw a line between what is cause and what is effect. Did interest differentials lead to the dollar's rise against the yen, and did this attract a large number of trend followers, which led to a further strengthening of the dollar? Perhaps yes. One other point is worth noting. If enough participants expect a particular effect, the prophecy often becomes self-fulfilling. Their own market actions bring about the expected result. Is this the reason underlying the relative success of technical analysis, at least in the short-run "" namely that most participants believe in it?
The event which has provoked the above speculation "" I am using the word in its classical sense of contemplation, not the more modern sense of buying or selling something in the hope of profiting from price movements "" is the well-publicised CRB scam. And, I intend to focus on two principal issues relating to CRB and the regulatory authorities, particularly the RBI. The first one concerns the criticism being levelled at the RBI for not opening the can of worms earlier. If it came to know of the irregularities as early as six months ago, was it not right to pull the plug then itself? While a precise answer would depend on the nature of those irregularities, the fact remains that whatever they be, the decision in real time would never be easy. Would action at that time have helped mitigate the losses the creditors are now likely to suffer "" or would it have merely precipitated an early collapse, destroying whatever chance there may have been of the company being solvent? Difficult to answer "" particularly in
the case of a financial intermediary. The business, as Keynes remarked, is based on an illusion "" of the lenders that they will get their money back. Once the illusion is shattered the business collapses. The decision to deliberately shatter the illusion is not an easy one.
The second point relates to the guidelines recently issued by the RBI to banks undertaking warrant encashment business on behalf of clients. These are very detailed "" a cap of Rs 10,000 on each instrument, restriction of the facility to a few branches, daily advice of encashments by fax, etc. The objective of the guidelines is of course very laudable "" namely that another bank should not fall into the same Rs 58 crore trap in which the SBI has fallen. And yet a thought keeps recurring: Are such detailed guidelines the best way of achieving the desired result? Would a more general caution and advice to banks to review and tighten their control systems for conducting warrant encashment business not have been more effective?
Personally, I am more inclined to the latter approach, if only because it would make bank managements think about the risks involved, appreciate and evaluate them better, and evolve their own control systems. Prescribing detailed procedures is surely the job of bank managements, not the supervisors. The problem with overdetailed regulation is that it makes thinking for oneself redundant as far as the regulatee is concerned. And, since no amount of detailed regulation can cover all possible eventualities, the best defence against the kind of fraud perpetrated by CRB on SBI is to encourage the average bank officer to put on his thinking cap. Detailed supervisory regulation is no substitute for well trained managers of banks, used to thinking for themselves and managing risks. And, the thinking needs to focus on both qualitative and quantitative analysis. Since detailed regulation has perforce to be quantitative, qualitative aspects get overlooked.
In short, a more lasting and effective way to avoid such frauds is to foster a culture of analysis and risk management within the banking industry "" not spoonfeeding of every procedural detail by the regulator.
This apart, there are reportedly 4,000 finance companies in India with a minimum capital of Rs 25 lakhs, now the threshold for registration with RBI. Any effective supervision of such a large number is impossible. (Thailand has just 91 and even then the central bank governor wants as many of the finance companies as possible to disappear through mergers.) Rs 25 lakhs is an absurdly low figure and the RBI needs to make up its mind about how many it can effectively supervise. This would allow it to draw a net worth (or asset size) threshold: those below it will be merely registered, and those above, registered and supervised. The distinction should be widely publicised and the NBFCs asked to indicate on their letterheads and other stationery, including fixed deposit receipts, the category they belong to. The supervisory authorities also need to consider how they could encourage a consolidation of the industry.
Lastly, there must surely be hundreds of arrangements similar to CRB's with SBI, across the banking industry. Why then the assumption of fraud/corruption and raids on bank officials? Surely such actions should be taken only when the concerned bank's management suspects mala fide on the part of the officials and complains to the investigative agencies?
