There is a theory in economics devoted to the failure of markets which speaks of a situation when the allocation of goods and services by a free market is inefficient. Market failures result when individuals or corporate organisations pursue greed in the name of self-interest, which, in turn, leads to pernicious innovations in financial trading that result in catastrophic disruption in wealth creation or redistribution. The theory propounds that market failures can be traced to information asymmetries, non-competitive markets, principal–agent problems, externalities or public goods. When markets fail, the case for government intervention in a particular market is strengthened manifold.

However, there is a case of regulatory failure in market crashes. In a New York Times article analysing the root causes behind the 2007-08 financial crisis, Edward L Glaeser, professor of economics at Harvard, argued that it was the regulators, not the capitalists, who had really failed the system. “Certainly, the shenanigans on Wall Street remind us that capitalists are not angels, and that, unchecked, their mischief can do much harm. But the point of financial market regulation was to ensure that misbehaviour would not imperil the entire system. Our public system failed to protect taxpayers from the costs of bailing out investors. The failures of our regulators shouldn’t be much more surprising than the wrongdoings of investment managers. After all, governments are made up of imperfect humans also.” This crisis, like most previous crises, should remind us of the frailty of both individuals and regulatory institutions, he remarked in his article.

The analysis is spot-on. Of all American financial sectors, markets were the most regulated in 2008. If a giant financial bubble could still burst, which sent shockwaves across the world, the problem was certainly not lack of regulation but haphazard regulation, which gave rise to the housing bubble. Regulators seemed not to have learnt any lessons from the spillover effects of the dotcom bubble, which had burst just seven years before.

The bubble is an apt metaphor here – asset or stock prices are inflated beyond all rational proportions inside a brittle structure that is expanded based on nothing but speculative air, and vulnerable to a sudden fracture. Major speculative bubbles have been known to occur from time to time, with ruinous effect. As long as hedging and betting broke no laws, there was nothing legally wrong about them or even the unpleasant spectacle of them coming unstuck. If economic bubbles have hijacked public policy, it is because of the failure of regulators to set the rules and enforce them when practitioners were operating at the edges. Regulators happily relaxed the rules at every turn, accelerating the natural pricking of the bubble.

If economic bubbles have hijacked public policy, it is because of the failure of regulators to set the rules and enforce them when practitioners were operating at the edges

The Crisis Years

In the run-up to the financial crisis of 2007-09, derivatives as financial innovations were introduced and manipulated to get super-normal profits. These instruments were not new, but derivates and other financial products in the name of innovation hobbled the genuine course of financial markets worldwide. The failure of insurance/mortgage companies like Fannie Mae and Freddie Mac was caused by the reckless use of these complex financial instruments. There was no major change in the value of underlying assets compared with the derivatives. This whole cycle of trading in virtual assets created conditions where, at the peak, nobody was there to pump in more money, leading to the crash. During bad times, people think to save, which leads to shortage of money in the market and hence businesses suffer. This leads to people receiving pink slips.

But for government intervention in 2008-09, the housing market in the US would have completely collapsed owing to the subprime crisis; too-big-to-fail investment banks would have collapsed under over-leverage; and production lines would have come to a standstill in automobile companies because of their ill-advised manufacturing policies. There was a time when Alan Greenspan, US Federal Reserve Chairman from 1987 to 2006, was viewed as a demi-god of financial markets. He insisted that it was difficult to say when a market bubble had formed, so it was better to let bubbles burst and leave the cleaning up exercise to markets themselves. Ben Bernanke, his successor, held on to this philosophy. In effect, this guaranteed huge private gains in the cyclical upswing, but required government rescues in a downswing. The yen for government rescues vanished completely once the public came to know that it was pure greed that had led to the systemic failure. Today, the word “bailout” is suspect in public eyes.

Yet, mature free markets also learn from their failures. The direct regulatory result of what has come to be known as the Great Recession is the Dodd-Frank Wall Street Reform and Consumer Protection Act, which aims at improving the stability of the financial system. This law, full of complexities, came into force on 21st July 2010. Regulators are more aware of the threat of systemic risk, consumers have an agency looking out for their interests, and banks are better capitalised and more limited in the risks they can take.

So far, the Act has worked well, but critics say Dodd-Frank is just a step forward, not a landmark legislation that cures all ills. They aver that the law has also left big holes that could make the system more vulnerable to future market disruptions, too-big-to-fail banks continue to live on, and they are as potentially capable of creating chaos as before. “Banks are way larger now than they were going into the crisis,” said Cornelius Hurley, Director of the Center for Finance, Law & Policy at Boston University, quoted in Bloomberg BusinessWeek recently. “Despite hundreds of pages of law and thousands of pages of regulations, the system itself is not any safer, to the extent that it’s at the mercy of six clearly too-big-to-fail banks.”

The US government had acted swiftly to plug the gaps that led to the spectacular collapse of once-invincible energy giant, Enron Corporation. Enron’s stock value diminished over a series of financial scandals that erupted in 2001 after the corporation collapsed, costing thousands of employees their jobs and wiping out billions of investor dollars. Shareholders lost nearly $11 billion when Enron’s stock price, which gained a peak $90 per share during mid-2000, decreased to less than $1 by the end of November 2001. The US Securities and Exchange Commission (SEC) began an investigation into the phony accounting practices at Enron. In December 2001, Enron filed for bankruptcy under Chapter 11 of the United States Bankruptcy Code. Enron’s $63.4 billion in assets made it the largest corporate bankruptcy in US history until WorldCom’s bankruptcy the following year.

The phony accounting at Enron and the bankruptcy of WorldCom months later prompted Congress to pass the Sarbanes-Oxley law. Interest groups are still trying to build political support – without much success – to review long-standing rules that govern companies, as well as parts of the 2002 Sarbanes-Oxley law which impose stringent responsibilities on accountants, board of directors and corporate executives.

The Right Steps

Mature markets learn and try to fix their problems. What about India? What is our record on the learning curve? When we consider the latest legislative developments, we have reason to cheer. The Companies Bill, 2012 is a step in the right direction. And the Banking Laws (Amendment) Bill 2011 – which has put new bank licences back on the horizon – can make valuable contribution to achieving the elusive goal of financial inclusion. Experts say the banking amendment bill could well be India’s Glass-Steagall moment. The Glass-Steagall Act was a landmark legislation promulgated in 1933 after the Great Depression in order to split pure banking and investment banking activities. That Act was repealed through the Gramm-Leach-Bliley Act of 1999, which is now blamed for sowing the seeds of the current financial crisis.

If we reflect on the Enron case, we find that the Satyam scandal had a number of symptoms in common with the Enron debacle. We have also had other large financial market scams like C B Bhansali, UTI 64, Ketan Parikh, Harshad Mehta, etc. The difference between the US and India is that while the failures were absorbed by few regions in India, the bubbles in the US were very large in size and the tremors of the bust were felt globally. Besides, due to the conservative policies of the Indian government, we have been more or less insulated from global crises.

Yet, that won’t absolve our regulators if they fail to learn lessons. Let’s take a look at the Satyam scandal, a massive accounting scam that sent shockwaves through Indian industry and took the country’s fourth largest outsourcing firm to the brink of destruction. Ramalinga Raju, the promoter of the firm, revealed in 2009 that he had for years been overstating profits. The scandal exposed the extent of violation of all prevailing corporate governance laws. Yet, the authorities took pains to cast the scandal as an exception, a mere aberration, rather than the rule in order to salvage confidence in the capital markets. Several commentators, however, pointed to the scandal as a sign of the malady afflicting corporate governance in India. Investors and regulators called for strengthening the regulatory environment in the securities markets. In response to the scandal, stock market regulator Securities and Exchange Board of India (SEBI) revised corporate governance norms as well as financial reporting requirements for publicly-traded corporations listed in the country. SEBI also strengthened its adherence to the International Financial Accounting Reporting Standards.

Mature free markets learn from their failures – the Dodd-Frank Wall Street Reform and Consumer Protection Act is the direct regulatory result of the Great Recession

In addition, the legal framework governing companies in India is finally getting a long-overdue makeover. The existing Companies Bill, which dates back to 1956, had clearly become outdated. The Companies Bill, 2012, which has been passed by the Lok Sabha, is supposed to set a new code of corporate conduct and is aimed at changing the securities laws to make it easier for shareholders to bring class action lawsuits. The bill, when voted into law by both houses of Parliament, will mark the end of more than three years of debate over the framework of checks and balances to prevent fraud, make corporate boardroom decisions more transparent and hold auditors as well as directors accountable.

The proposed legislation will empower the Serious Fraud Investigation Office (SFIO) – an agency mandated to investigate corporate scams – with statutory status armed with the authority to file chargesheets, impose punitive measures and, in specific instances, even arrest persons found guilty of corporate crime. The SFIO investigation report will be treated in a manner similar to a police report in a court of law. This will allow faster prosecution in SFIO investigated cases. The bill also seeks to impose a limit on the tenure of an independent director on the board of a company, besides making it mandatory for companies to rotate auditors within a stipulated time frame. Among the new provisions, the clause mandating companies to spend 2 per cent of their average net profit during the preceding three years on corporate social responsibility is also noteworthy.

It is still premature to say if the bill, once made into law, will break the nexus that exists in corporate boards which keeps the public in the dark about key information. The nexus can only be broken if the government reforms political funding to ensure transparency in the relationship between companies and politicians/political parties. The unholy collusion between the corporate class and the political establishment is widely held to be the reason for the slow progress of investigation into the Satyam scandal. This collusion could potentially blunt the efficacy of the proposed law on corporate governance and delay justice in future corporate scams.

Reforming India’s corporate governance culture is just one facet in the task of taking forward India’s economic liberalisation. More important is the requirement for reforms in the real sector, especially in mining, steel and railways. Regulators in India are extensions of the respective ministries and largely populated by bureaucrats. There is a strong case to choose individuals who have hands-on domain expertise as regulators.

Need for Reforms

Different sets of indicators have been used in attempts to measure the financial development of economies. Starting in 1999, the World Bank began work on a database on financial development and structures across countries. The most recent World Bank studies have expanded the financial development and structure database. These studies have included a select number of financial system indicators to gauge a country’s financial development. These include indicators for the size of the financial system, including liquid liabilities-to-GDP, currency outside banking system-to-base money and financial system deposits-to-GDP; banking system indicators for size, structure and stability; indicators for capital markets and the insurance sector; and indicators for financial globalisation, such as international debt-to-GDP and remittance inflow-to-GDP.

The World Economic Forum (WEF), which began releasing its annual Financial Development Report (FDR) in 2008, provides an index and ranking of the world’s leading financial systems. The FDR defines financial development as “the factors, policies, and institutions that lead to effective financial intermediation and markets, and deep and broad access to capital and financial services”.

In tune with this definition, the FDR takes into account different aspects of development of a financial system, presenting them as “seven pillars” of the financial development index (FDI). These fall into three categories. The first is factors, policies and institutions – “inputs” which allow the development of financial intermediaries, markets, instruments and services. This comprises three pillars: institutional environment, business environment and financial stability. The second category is financial intermediation – variety, size, depth and efficiency of financial intermediaries and markets that provide financial services. This includes three more pillars: banks, non-bank entities and financial markets. The final category is financial access which includes the last pillar related to access of individuals and businesses to different forms of capital and financial services.

It is a fairly recognised truth that India does not measure high in its financial development in any of the criteria set by either the World Bank or the WEF. However, India is relatively well placed in terms of development of non-banking financial services and financial markets. Within financial markets, India occupies a decent spot in development of its foreign exchange and derivatives markets. Some of the sub-indicators in which India ranks well are regulation of securities exchanges and currency stability.

An Asian Development Bank study, analysing World Bank reports, commented in 2011 that India’s institutional environment is considerably weaker, “a consequence of its lower levels of financial sector liberalisation as well as a low degree of contract enforcement. India’s business environment is also affected by two particular challenges: an absence of adequate infrastructure and the high cost of doing business. These areas of difficulty translate into highly constrained financial access.”

Let us take just two areas for consideration: capital market reforms and the banking sector. The government is keen to see through capital market reforms. A vibrant corporate debt market will help not only large industries but also small and medium enterprises. No doubt, to ensure financial deepening, India must put in place a robust banking system and a developed capital market. Capital markets can play a significant role in achieving financial inclusion by making available multiple financial products and services tailor-made for the masses, and enhancing investor protection. It also demands more integration of the network of banks, exchanges, insurance companies, fund houses and other bodies to bring about cross-selling.

This will, in turn, call for financial literacy and the optimum use of technologies to spread access, besides wholesome competition. The government must take steps to widen the stock market base, increase liquidity and reduce transaction costs. Also required are expansion of traded instruments, technological upgrade, raising investor confidence by increasing the effectiveness of surveillance and increasing investor protection, promotion of greater self-regulation, transparency and disclosure norms, and salutary competition among market intermediaries. These are the critical challenge areas. Without addressing them, any reform of the capital market could well be mere window-dressing.

Since 1991, the banking sector too has witnessed sweeping changes, including the elimination of interest rate controls, flexibility in reserve and liquidity requirements, and reform of lending norms. The Banking Laws (Amendment) Bill 2011, which has been passed by the Lok Sabha, seeks to strengthen regulatory powers of the Reserve Bank of India (RBI). The bill was passed even though it meant dropping a clause that would have allowed commercial banks to enter commodity futures trading. It is apparent that industrial houses will be allowed to set up banks as further deepening of the bank network will only be possible if promoters have deep pockets to spend on technology and talent. It will be interesting to see how fast RBI is willing to open its doors for new banks and how many aspirants will get the central bank’s approval.

In India, the Companies Bill, 2012 will empower the Serious Fraud Investigation Office (SFIO) – an agency mandated to investigate corporate scams – with statutory status

India needs hundreds of banks as the country still remains one of the most under-banked nations among the bigger economies of the world. Banking penetration depends on loan-to-GDP ratio. It is measured by the amount of domestic bank loans made as a ratio of the country’s GDP. India’s loan-to-GDP ratio was 75 per cent in 2011 while China’s was 146 per cent. The US has achieved a ratio of 233 per cent, with the UK close behind at 214 per cent. The measures implemented so far in India – the business facilitator and correspondent methods – have clearly failed to bring about banking inclusion in India, owing in no small measure to inherent flaws in this business model.

In a thought-provoking article in the April-June 2010 issue of Inclusion that was devoted to financial deepening, C Rangarajan, Chairman, Economic Advisory Council to the Prime Minister, emphasised the need for “expanding credit to agricultural and allied activities”. He wrote: “While banks have achieved higher growth in this area in recent years, the momentum has to be carried further. And this is particularly necessary when it comes to provision of credit to small and marginal farmers…. Today, the proportion of institutional credit going to sub-marginal and marginal farmers is far lower than for other classes of farmers.”

In the article, he asked several important questions: “What changes do we need to introduce so that credit flow to this class of farmer households can be accelerated? Should banks think in terms of supporting other institutions which are in a better position to lend to marginal and sub-marginal farmers? Can the banking system through its present mode of distribution of credit meet this challenge? As a solution, banks are looking at the business facilitator and correspondent models. If we are to ensure greater financial deepening, a re-look at the organisational structure of our rural branches is also called for. Banks need to think deeply on how to meet the challenge of meeting the credit needs of the marginalised. Financial inclusion is no longer an option; it has become a compulsion.”

To safeguard financial inclusion, the government could draw from the September 2008 report of the High Level Committee on Financial Sector Reforms headed by Raghuram Rajan, now the Chief Economic Adviser to the Finance Minister. The committee had recommended allowing enhanced entry of private, well-governed, deposit-taking small finance banks on the conditions of higher capital adequacy norms, clampdown on related party transactions and lower allowable concentration norms.

In real terms, India has miles to go before we can claim success in financial development as outlined by the World Bank and WEF. As Rangarajan puts it in his article, India needs to “strike an appropriate balance between the need for financial innovations to sustain growth and the need for regulation to ensure stability.”

In the light of failures in the West, the critical lesson we must draw is to undergird financial inclusion and financial development efforts with effective regulation.