Global Financial

Crisis
Lessons for India

Institute of Public Enterprise

Hyderabad
March, 2010
Global Crisis – The Cascading
Effect
 Sub-Prime Crisis

 Financial Crisis USA

Europe
Asia
Africa
 Economic Crisis

 Unemployment Crisis
Sub-prime Crisis

Sub-prime crisis can be best understood

by analyzing the following :
 Problems in Housing Market
 Problems in Financial Market
 Government & Industry Responses
Problems in Housing Market
 Excess Housing Inventory ( Overbuilding during boom
period, speculation, easy credit policies, ARM practices –
innovation for giving loans to new service entrants)
leading to
 Decline in housing prices ( Housing bubble bursts,
Household wealth declines) leading to
 Inability to refinance mortgage ( poor lending borrowing
decisions, ARM Adjustments) leading to
 Mortgage delinquency & foreclosure land consequent
mortgage cash flow declines
 SECURITIZATION PROCESS
(Risk Transfer)

Borrowers Servicer Rating Investors

Senior

SPV Mezzanine
(Pay Through / Pass
Originator Through Certificates)

Subordinate

Arranger Credit Enhancement Structural Credit Enhancement

 Credit Default Swap (CDS)
 A specific kind of counterparty agreement which
allows the transfer of third party credit risk from one
party to the other. One party in the swap, the “
protection buyer” is a lender and faces credit risk
from a third party, and the counterparty in the credit
default swap , the “protection seller” agrees to
insure this risk in exchange of regular periodic
payments ( essentially an insurance premium). If the
third party defaults, the party providing insurance /
protection will have to purchase from the insured /
protected party the defaulted asset. In turn, the
insurer pays the insured the remaining interest on
the debt, as well as the principal.
 Characteristics of CDS
 Underlying or reference credit can be either a
single entity or a group of entities
 The exercise conditions, which can be a credit
event
( such as rating downgrade or a default), or an
increase in the credit spreads.
 The pay off function, can be a fixed amount or a
variable amount with a linear or non-linear payoff
 A common feature of existing credit derivatives is
that their tenors are less than the maturity of
underlying credit
(for example a credit default swap may specify that a payment is to
be made if a 10 year corporate bond defaults at any time during the
next two years)
 Credit Default Swap
Mechanism of Operation

Protection Buyer Protection Seller

Reference Credit
 Credit Default Swap Market
 The estimated size of world CDS market is around 62
trillion USD
 This is about 3 times size of US stock market, 6 times of
the mortgage market and 12 times of US treasury bill
market.
 Top 25 banks were found to be holding $ 13 trillion in CDS.
Speculative investors like hedge funds also buy and sell
CDS instruments from the sidelines without having any
direct relationship with the underlying credit. It is like
betting on a sports event.
 The protection sellers also buy protection from others to
hedge their position ( form of re-insurance). The chain goes
on and on. The actual total credit exposure could be as
high as $ 200 million on a $ 10 million loan.
 CDS Characteristics
 CDS is a swap instrument and as such is not regulated
either by banking or by insurance regulatory authority.
 Banks are not required to allocate capital under capital
adequacy requirement for CDS exposures
 Loans are required to be funded. For giving loans banks
need to borrow / raise funds. However, for CDS exposure,
banks do not need prior funding.
 Hedge funds operate in a big way in CDS market because
of absence of funding requirements. They offer credit
protection much beyond their capital base.
Problems in Financial Market
 Decline in mortgage cash flow resulted in bank losses
(loss on mortgages, loss on mortgage securities) – lead to
depletion of bank capital level – Failure of Washington
Mutual, Wachovia and Lehman Brothers.
 Bank failures resulted in liquidity crunch for business –
harder to get loans – higher interest rates for loans
 Overall negative effect on the economy – Decline in
business environment, risk of increasing unemployment,
stock market crash resulting in further reduction in
household wealth
Government & Industry
Responses
 Central Bank Actions – Lower interest rates, increased
lending, infusion of liquidity
 Stimulus Packages
 Selective Bailouts
 Systemic Rescue – Bank recapitalization
Third Regional Conference for
Middle East & North Africa at Doha

 The conference decided to address the following corporate

governance issues :
(a) The regulatory and supervisory powers of central bank
should be extended to investment banking and related non-
bank financial intermediation.
(b) Risk management frameworks, processes, and
implementation practices require reform in order to redress
the shortcomings revealed by the turmoil.
© The role and form of regulation of credit rating agencies
need to be addressed
(d) Executive remuneration and incentive structures need
to be linked to long-term performance and risk profile of
firms. More disclosure on executive remuneration schemes
is required and companies should put their remuneration
schemes to shareholders scrutiny and approval.
Doha Conference
 Corporate governance practices need to be strengthened,
in particular by increasing board competence and
responsibility. Board members need to have up-to-date
knowledge on financial issues and risk management to
fulfill their functions. Board should conduct annual
evaluations of their performance and report to
shareholders.
 Governance and accountability of regulators are equally
essential.
 Effective creditor rights and insolvency systems and the
development of strong rescue and restructuring
frameworks are important.
 Good corporate governance is important not only for listed
companies, but also for State and family owned
enterprises.
Problems Identified and Lessons
Learned
 Health of economy is linked to the health of consumers ( Housing
bobble burst lead to economic crisis)
 Entire “Credit Default Swap” market was largely unregulated.
Being a form of credit insurance it was neither regulated by
banking regulatory authority nor by insurance regulatory authority.
CDS market should be regulated. Setting up an exchange to deal
with CDS contracts would be advisable.
 Change from an ‘investor pay model’ to ‘issuer pay model’ is the
root cause of problem with rating agencies.
 Investment banks “game” or manipulate the rating process by
reverse engineering the rating models. They engage in
sophisticated optimization to construct collateral pools and
structuring techniques to reap the desired results. Rating agencies
should not be permitted to do investment banking consultancy and
deal structuring.
 Securitization market was largely unregulated. There should be
transparency as regards to off-balance sheet risks
 It is better to keep the credit risk and manage it rather than allow it
to grow in an unmanaged, unmeasured way.
Problems Identified and Lessons
learned
 The Board must ensure integrity of risk management
system, analyze periodically risk exposures of the
company and impact of new financial instruments on the
financial health of the company.
 The Board must have an appropriate whistle blowing policy
within the organization. Whistle blowing by employees can
hide the ignorance of directors to save an imminent
disaster.
 Securities and future markets need to be integrated.
 For conceptual & regulatory matters, regulation of all 4
industries, viz., banking, insurance, futures and securities
should be under a single umbrella.
 Crises of global dimension need to be tackled by a global
consultative approach – through better understanding,
mutual help and coordinated efforts.
 Multi-lateral institutions( IFC / World Bank etc) must help
easing the crisis and averting the disaster
 Lessons for India
 Strengthening Regulation – Super Regulator?
 Greater transparency for off-balance sheet risks / transactions.
 Strengthening Corporate Governance Environment. – Making Board more
accountable, Enlightening/ educating Board, Prudential Disclosure, Whistle
Blowing Policy etc.
 Better regulation of Securitization deals
 Greater control / regulation of Rating Agencies – Make them more responsible
and accountable.
 Regulation of cross border deals and transactions of Indian Banks / FIs.
 Framing suitable guidelines before new financial instruments are introduced.
 Efficient credit allocation, puncturing market bubbles through appropriate
policy announcements.
 Timely intervention by Central Bank (RBI) & Finance Ministry to minimize the
damages.
Thank You