Learnings from crisis

by Sudip Bandyopadhyay
(CEO & Director, Reliance Money)

Financial crisis have, by and large, exhibited a repetitive pattern, demonstrating the inability, or unwillingness, of financial market participants to learn.

Charles Mackay, in his book Extraordinary Popular Delusions and the Madness of the Crowds, says that while episodes of panic and disasters have their own distinctive features, they exhibit a common feature – that they are all preceded by a period of apparent prosperity when it is possible to rapidly acquire fortunes ‘otherwise than by the road of plodding”.

In their study of 18 financial crises in the US, economists Carmen Reinhart and Kenneth Rogoff of Harvard Business School found that there were ‘stunning qualitative and quantitative parallels across a number of standard financial crisis indicators’. Ahead of each big financial shock, house prices rose rapidly, as did equity prices; current account deficits ballooned; and capital inflows accelerated.

Financial crises, either global or domestic, transform ‘something close to universal trust into something akin to universal suspicion’ as Galbraith remarked in his book The Great Depression. Under these conditions, it becomes difficult for regulators and legislators to make the wisest decisions or take the best measures. Regulations originating in a crisis tend to be extreme and such measures often lead to expensive regulation.

The Sarbanes Oxley Act is one such example. The question is: if the financial crisis could not be detected despite the expensive disclosures and risk management requirements of this act and NYSE rules, are such rules serving the purpose? The recent banning of short sales in the US, Europe and Australia is another example. Banning of short sales is an extreme measure which has not worked in any market. It does little to arrest the decline in prices; on the contrary, when the ban is removed, a flood of pent up sales push the market down further. This was tried in India too on a couple of occasions, and with little effect. We ought to refrain from taking any quick-fix regulatory measure – either as a precautionary or prophylactic step or for lifting the market sentiment. Market sentiments cannot be talked up or down and when fear grips the market it would be futile to try and impact the prices by comforting statements for example, the famous Greenspan speak of ‘irrational exuberance’ had affected markets only for half a day.

Markets are known to respond to the casual market-reviving measures only casually, as they did to the recent SEBI Participatory Note-related policy changes. What works are measures that ensure that liquidity never dries up. That is the responsibility of the central banker.