Future of Financial systems

Global financial markets literally rode on a roller-coaster last week, first dropping sharply in response to news about the Lehman Brothers bankruptcy filing and then recovering just as sharply as the US government bailed AIG out and several central banks announced their willingness to pump in large amounts of liquidity to provide markets with a lifeline. At the end of the week, if one were to just go by stock market index values around the world, it might seem like nothing had happened.

However, many people would agree with the view that the events of the week represent a major discontinuity in global finance. The structures and operating boundaries of all the players in the game today, private and public, will be examined and re-examined. Whether this will result in a broadbased co-ordinated set of reforms is too early to assess. At the end of the process, the conclusion might well be that radical solutions that address today's problems actually exacerbate other risks. These are issues to think seriously about over the coming weeks and months. Meanwhile, the immediate concern is with the survival of the existing system. Is it now in irreversible decline or showing signs of resilience?

The “irreversible” decline view undoubtedly has several adherents and events over the next few days may well prove them right. But, let's examine the arguments in support of the “resilience” view. Two sets of factors need to be taken into consideration. One of them is structural, reflecting a long-term trend. The other is cyclical, providing an opportunity for the kind of policy response that we saw last week without provoking fears of a broader macroeconomic fall-out.

The structural trend that has been in evidence over the past few years and whose impact is likely to continue is the globalisation of financial exposures. Emerging economies, as a group, have clearly been significant contributors to global growth over the past decade. However, their increasing openness to international capital has provided greater opportunities to global investors to tap into the returns that the growth offers (as well as expose themselves to the risks).

Diversification as a way to mitigate risks is the first rule of portfolio management. The ability to diversify portfolios globally has provided financial institutions with access to a range of asset classes whose price movements are less and less correlated with each other. For example, investments in China and India, whose returns are predominantly generated from domestic markets, are likely to be able to resist the pressures that investments whose returns are more closely linked to the US and other vulnerable markets are facing.


The cyclical opportunity stems from lower oil prices. Even as recently as a few weeks ago, with prices hovering around the $150/barrel mark, the willingness of central banks to infuse even small doses of liquidity to shore up asset prices would have been in doubt. As much priority that central banks may give to the integrity of their financial systems, managing inflation still remains their primary responsibility and the trade-off between the two was acute in the first half of the year.

That the US Federal Reserve went against the grain in January, sharply lowering rates, highlighted the seriousness of the financial problem. However, given the macroeconomic risks of easing interest rates too early in the cycle, there was clearly an argument to be made in favour of more selective, targeted solutions focused on vulnerable institutions, despite the obvious moral hazard arguments against such solutions. The practical consideration of saving the situation first and worrying about the nuances later will almost always prevail.

However, as the inflationary threat recedes, particularly in countries that had fully passed on the oil price increases to domestic consumers, central banks can shift from targeted bail-outs to more traditional approaches, lowering interest rates and cash reserve requirements to stimulate economic activity as well as asset prices. Virtually all major central banks should be entering this phase over the next few months if the oil price situation remains favourable. Of course, another shock to the system could well materialise, completely disrupting current calculations, but barring that, macroeconomic conditions are becoming increasingly supportive of the “resilience” view.

What implications do these events have for emerging economies? Obviously, the benefits of globalisation from the viewpoint of global investors do look like risks as far as the destination countries are concerned. As we saw, the exchange rate is usually the first casualty of sudden and large portfolio movements. The difference between the Asian crisis of 1997 and today is the huge foreign exchange buffer that emerging economies have built up to protect themselves against just such an eventuality. For the time being, they generally appear to have withstood the shock. Their currencies have depreciated sharply but no panic has set in about their ability to meet all obligations, even in the worst case.

In a sense, their ability to weather this shock vindicates their decision to “buy” insurance in the form of huge reserves, paying the price in terms of domestic monetary and financial distortions. But, as is becoming evident from the debate in India, it is always tempting to justify slow movement on reforms by arguing that a more liberal domestic environment would have made the domestic financial system even more vulnerable to the global turbulence. The reforms agenda should not be held hostage to the current crisis; rather, further reforms should be seen as an opportunity to find a more efficient and sustainable balance between growth, returns and risk.

The one thing that this crisis has brought to the fore is that both mature and emerging economies now face essentially the same set of questions about the future of their financial systems. How are intermediation and investment activities to be structured? How is risk to be measured and provided for? What systemic roles should the government play? And, how best can governments and regulators in increasingly integrated markets co-ordinate to ensure that effective safety nets are in place and shocks can be contained? The answers to these will chart out the future of global and domestic financial systems, however they emerge from the current catastrophe.