RBI's reflex action on Lehman

Last week stood out for global knee-jerk regulatory responses to the turmoil in the financial markets. Regulators worldwide introduced measures to outlaw short selling of securities

The United Kingdom’s Financial Services Authority (‘FSA’) announced a four-month ban on short selling in securities of UK-based financial institutions by declaring that any increase in a short position or creation of a new short position in any UK bank or UK insurer, or their parent companies would amount to “market abuse”.

The United States’ Securities Exchange Commission (‘SEC’)announced tougher measures to punish “naked” short sales until October 1. Unlike the FSA, the SEC has not banned short-selling. It has only tightened enforcement against “naked” short sales.

A “naked” short sale is a sale by a person without being covered by an earlier purchase position, or an earlier holding, or a prior borrowing of the stock being sold. All other short sales are termed “covered” short sales and not universally prohibited.

Most jurisdictions treat short sellers on a footing unequal with “long” players. Different jurisdictions have imposed varying levels of prohibitions and regulations in relation to short selling. Many jurisdictions have banned naked short sales while others have introduced measures such as the “uptick rule” (permitting short sales only when the price is rising) or limits on the quantum of aggregate short sale position in any stock (as a percentage of the share capital), or price limits (linking the price in a short sale to the previously traded price).

Under fear of exposure of Australian banks to Wall Street banks that are now in the doldrums, the Australian Securities Exchange has imposed a complete ban on naked short sales until further orders. France, Portugal and Ireland too are reported to have taken similar measures against short-selling.

In December last year, the Securities and Exchange Board of India (‘SEBI’) and the Reserve Bank of India (‘RBI’) had announced their intent to bring in institutional involvement in short-selling by permitting foreign institutional investors and local institutions to sell short. A stock lending and borrowing mechanism was introduced this year to enable covered short selling, but it did not lead to major volumes due to universal opposition to the mandatory seven-day tenure for borrowing stock witin which positions have to be covered, preventing a longer term call on specific stocks in the cash segment.

India too has had a long history of regulating short sales. Each of the newly elected coalition central governments in the recent past has been vindictive with falling stock prices that would follow government formation. Ministers have summoned bankers to threaten them with action, and enforcement agencies have been unleashed on select players (Shankar Sharma of First Global is a prime example). The Indian corporate sector is perceived by market players to be the strongest lobby against short-selling.

Last week, it was not SEBI, but the RBI that contributed to India’s share of knee-jerk regulatory action. In a measure that sent panic signals across India’s money markets, and brought back memories of capital controls, the RBI took the unprecedented step of suspending the operations of Lehman Brothers’ Indian subsidiaries, citing the bankruptcy of the foreign parent.

Lehman Brothers Capital Pvt. Ltd was prohibited from contracting further liability from any “institution in India or outside” and from “making any foreign currency remittance”. Lehman Brothers Fixed Income Securities Pvt. Ltd. was prohibited from making any remittance to its overseas affiliates (including payment of dividend).

While many nationalists felt proud of the RBI for its timely alertness, it may prove to be a bad precedent. How much money could actually have been sent out by the Indian entities, and how such remittance could risk the Indian market system remained undisclosed. The RBI action would lead to an expectation that the central bank could take such measures each time a foreign parent of an Indian subsidiary goes bust.

The signal to the market was one of a panic-stricken RBI, so desperate, that it had to pre-empt outflow at any cost. The market speculated that the undisclosed exposure of the Indian market system to the local Lehman entities could be so huge that the RBI had to strive to protect every dollar from flowing out of India.

Such indistinct case-specific suspension of the law would only lead to foreign investors perceiving a regulatory risk to their investments in India. In times of financial stress their investments could get blocked without any grievance redressal mechanism in place.