Financial Sector: Continuous Watch Can Ensure Peace

Dr B K Mukhopadhyay

(The author is a Professor of Management and Economics, formerly at IIBM (RBI) Guwahati. He can be contacted at m.bibhas@gmail.com)

The financial sector virtually drives the economy. Any major deviation affects the economy to a significant extent. Risk management has emerged as the main mover.

It is a well-known fact today that the financial system is one of the most important inventions of modern society, with the primary task being to move scarce loanable funds from those who save to those who borrow to buy goods and services and to make investments in new equipment and facilities so that the overall economy can grow, backed by stability, and at the same time increase the standard of living. The financial system determines, among others, both the cost of credit and how much credit will be available to pay for the thousands of different goods and services. As such, the happenings in this system have a powerful impact on the health of the overall economy, whether regional or global. The financial world has to be more cautious than ever before, as the fluctuations cannot be wiped out. Still, a number of economies are striving hard to tackle the economic front, and naturally, any laxity could invite further problems.

That is to say, the time is especially ripe to have more updated internal risk-management processes. Newer risks have surfaced over time, and the capital markets [where the banks are still the major players] cannot simply be expected to behave as per one’s expectations. That is why constant watch over the trends should continue to be there. The regulators as well as the policymakers have to remain alert in spite of the fact that a number of corrective measures that were being taken have been found to be reality-based and market-oriented. Breathing easier, however, is just a temporary affair as long as the problems remain manifold and no short-cut solution is there to stop recurrences.

Risk management rules the game

Intensive risk management efforts are continuing, and the sooner the newer threats are detected, the better. Signs of recession and slowing down of the pace of economic growth and activity are very much alive, inclusive of those biggies in Asia as well [viz., India, China, Japan, and Singapore in particular].

The immediate systemic failure of the banking system and its risks may be said to have receded, but the threats loom large inasmuch as there are many unknown factors still to be countered. How effectively and how fast the upcoming plans will be implemented remain unclear. For example, the future of hedge funds—a major collapse of $ can trigger a systematic shock. Side by side, big liabilities in the credit-default swap market are no less capable of triggering a financial accident. 

That is equally true for the investment banks.

Incidentally, it may be mentioned that an investment bank is an intermediary that performs a variety of financial services that include: underwriting; acting as an intermediary between an issuer of securities and the investing public; facilitating mergers among corporate organizations as well as acting as a broker for institutional clients. The unique role of an investment bank resumes with pre-underwriting and counselling and continues after the distribution of securities in the form of advice. Goldman Sachs [founded in 1879 and became a listed company in 1999 having been a partnership that provided securities and investment management services plus investment banking] and Morgan Stanley [founded in 1935 and merged with Dean Witter, Discover & Co. in 1997, functioned in the arena of institutional securities, wealth management, and asset management]—the last two investment banks in the U.S. have since changed their status to become bank-holding companies, which, in turn, allows them to accept deposits from investors. This sort of change allows them to raise more funds by opening commercial banks, and this move, part of the restructuring efforts on Wall Street, also gives them access to Federal Reserve support.

Thus, the transformation of investment giants into licensed deposit-mobilizing banks marked the end of an era for Wall Street. This radical revamping completes the biggest overhaul in high finance since the Great Depression in the 1930s. To what extent Goldman Sachs, under Federal Reserve supervision, could be regarded as an even more secure institution with an exceptionally clean balance sheet, as claimed, would be watched realistically henceforth, and only time can give the answer! In fact, the financial meltdown has been shaking the entire world this way or that. We, in India, have also been watching the recent developments in the Eurozone, among others, very intensively so that our economy’s growth momentum should not be lost.

After too much foot-dragging, uncertain occurrences, as well as ominous signals, it appears that at last we have arrived at a coherent and credible approach to, at least, preventing the recurrence of the collapse of the major banks of Europe and the U.S. Given the ongoing facts and circumstances, the steps taken so far are no doubt the most practical and direct solution; apart from ideological dimensions, both the US’ and European economies have been going the recapitalization route.

In fact, a financial crisis can be caused by, among others, an increase in interest rates; increases in uncertainty; asset market effects on balance sheets, problems in the banking sector, and, of course, the government’s fiscal imbalances. These lead to adverse selection and moral hazard problems worsening, which, in turn, pave the way for declining economic activity, bank panics, an unanticipated decline in price level [the recession looms large], and a foreign exchange crisis. It is better not to forget that the factors that cause financial crises still hover around.

Actually, it is confidence that emerges as the greatest casualty of the market crisis. To what extent such snapshot measures ultimately act as the saviour to shore up business confidence is to be watched. At times, the uncertainty factor becomes so strong that the leading financial institutions hesitate to credit smaller banks, which, in turn, fail to re-credit businesses or simply do not want to risk it. Private customers do suffer as well.

Unless the global banking system, which happens to also be the monetary circulation system for the non-financial sector of an economy, resumes higher credit business, the current economic slowdown and thereafter, the recession possibilities stricken by the confidence crisis could well emerge as a reality. Whatever it is, the damage from further meltdown, if it revisits, will be more tough—not only for the financial world but for households and companies—with the degree being different, at best.

Topsy Turvy is the World Economy

It is high time that international cooperation should come up with greater vigour, as global cooperation on this score is urgently awaited, backed by experience sharing. If the world again faces recession [too much inflation control may lead to this], it will be a very hard nut to crack!

Though the fact remains that the credit crisis and the high interest rate regime caused investment to simply dry up, considering the ongoing facts and circumstances, the entire process is to be run very cautiously, as increased spending means more importing of capital equipment, which, in turn, leads to slim current account surpluses and reduced global imbalances. The balance between spending and tax initiatives is to be maintained on the one hand, while on the other, the focus is reasonably expected to be on helping the poor economies while simultaneously treating investments that would also benefit Europe and the US in the long run.

The IMF is absolutely right in advising strong policy actions to mend the financial sector and macro-economic measures [monetary plus fiscal measures] so as to stimulate effective demand, and by now almost all economies have been pursuing these policies without being able to put a brake on the downturn. ‘A unified approach’ to financial problems and ‘strengthening the fiscal framework’ require a good bit of attention from all of the economies, big or small. If government policies fail to dispel uncertainty, reduced demand for consumer and capital goods will continue to prevail as a result of postponing expenditures by the household and business wings! The ongoing situation and happenings, thus, are to be watched intricately, countering the same calls for global cooperation at an unprecedented pace. The prevention of large-scale bank collapses is a must. Whatever it is, a continuous watch must be kept so that our economy remains protected. In today’s world, if Washington sneezes, Japan catches cold!