Sunday, July 27, 2008

Closure of financial firms

Business Standard has an excellent editorial on the problems of Sahara India Financial Corporation. It talks about the difficulties of shutting down financial firms.

Raghuram Rajan's report emphasises the importance of a mechanism for swiftly shutting down insolvent financial firms. For a role model, last weekend, the US FDIC closed down two banks. Notice how swiftly and smoothly these closures were done. Here is the stock information release that FDIC puts out about such an event and here's the press release that they put out.

Compare and constrast this with the ineffectual DICGC that we have in India. After 15 years of talking about financial sector reforms, we have not moved an inch on this.

Two consequences follow when closure of financial firms is made difficult. The competitive landscape is contaminated by the perpetuation of `zombie firms' who should be dead but aren't. These firms block capital and labour that can be more productively used by other firms in the economy. And, they reduce profit rates for healthy firms and adversely affect investment in the economy.

In India, difficulties of closure of financial firms is part of the package of excuses that is offered for blocking progress. E.g. it is claimed that derivatives trading cannot be allowed to take root because some firms will experience distress when making mistakes with derivatives, and since that distress is painful for the regulator, all firms should be denied the benefits of derivatives trading.

One of the crucial elements of the policy package which has worked out right for the equity market is swift closure of firms in distress. When NSCC sees a firm which has violated rules about margins, its trading permissions are immediately rescinded (even if this involves triggering off panic amongst its customers). If the firm is not able to quickly get back into the game with adequate capital, it is thrown out of exchange membership. The equity market stands alone in Indian finance with a vibrant creative destruction process: some firms die every year, and some new firms come about every year.

6 comments:

  1. The security markets also need to pull up their socks. Compare the Investor Protection Funds of our exchanges vis-a-vis SIPC of US (http://www.sipc.org/).
    Regards,
    Anonymous1

    ReplyDelete
  2. Hi ,

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    Cheers,

    ReplyDelete
  3. Well there is some work to be done on dealing with bank failures, but let us nor forget that it is absolutely essential that regulators have adequate supervisory powers to prevent blow-up of bank failures. Today, in the U.S., the Fed and SEC want more powers from the congress for regulatory oversight of the too big to fail investment banks, commercial banks and Government sponsored entities Fannie and Freddie. Prevention is better than cure, erring on the side of caution need not necessarily stifle innovation.

    http://www.washingtonpost.com/wp-dyn/content/article/2008/07/24/AR2008072401572.html

    ReplyDelete
  4. Ajay,

    The swiftness and weekend shutting is to avoid panics, as you very well should know.

    ReplyDelete
  5. While an EDUCOMP gets questioned by CLB for moving its share price to Rs. 2300 and then back to Rs. 500 in last year, another company Financial Technologies still gets away despite its share prices rraching Rs. 2800 and now languishing at Rs. 500. Why such shadow companies are not questioned now. Moreso, from teh fact that the company is promoting commodities exchanges including currency exchange even after its frims like DGCX, MCX, SNX,NBHC and Natioal Spot Exchange books could be open to an intersting concoction simialr to Satyam.

    Well, well, FT and group companies have given stakes to The economic times and Business standard owners. No wonder even tehse newspapers would be doubly cautions before even mentioning their name.

    ReplyDelete

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