The Hindu Business Line : Why central bankers should play `war games'

The latest e-mail alert from the Bank for International Settlements (www.bis.org), dated March 8, has a link to an interesting paper. Titled Architects of stability? International cooperation among financial supervisors, and authored by Ethan B. Kapstein, the paper was one of the presentations at the Fourth Annual Research Conference of the BIS held mid last year.

A paradox that the paper highlights is that the contemporary risk environment is "both more consolidated and more atomised at the same time". How? "On the one hand, large and complex financial institutions (LCFIs), which may have become both `too big to fail' and `too hard to regulate,' increasingly dominate the banking landscape."

As if that's not frightening enough, the other aspect is scarier: "These same institutions have worked diligently to shift at least a portion of their risks onto other firms and households via the instruments and markets that exist for such purposes." Which means, there's the small you and me at the end of the big picture!

Bank consolidation is a favourite theme of the Finance Minister. For instance, at the Bancon 2005 conference, in Kolkata, in November 2005, Mr P. Chidambaram urged trade unions to convince their top leaders about the merits of mergers. Dangerously, though, "bank consolidation can create diseconomies of scale, as opposed to the promised efficiencies that normally accompany such mergers and acquisitions," as Kapstein alerts. A point worth giving a thought to, therefore, before rushing banks into forced marriages, as one has been seeing of late.

A quote that can make you queasy is from Morris Goldstein — that since 1985, "there have been more than 65 episodes where banking problems in emerging economies got so bad that the entire banking system was rendered insolvent." It seems that in Asian countries the `fiscal costs of bank recapitalisation' range from 10 to 60 per cent of GDP.

The question that Kapstein raises is whether the supervisory architecture is well suited to governing or regulating the current structure of risk. His answer is in the negative, "given the opacity of the risks that we face; an opacity that is especially troubling given all the calls since the Asian crisis for greater financial transparency."

Five suggestions for central bankers

Should we, therefore, concur with Adam Posen, who wrote that "banks are inherently fragile and their supervision is inherently inadequate, making dependence upon banks dangerous"? Not necessarily, says Kapstein, even as he outlines five suggestions "to build a closer working relationship between `independent' central banks and quasi-independent financial regulators, and between them and elected officials within and across governments."

The effort involves "not just international institutions like the BIS and IMF, but also foundations, universities, think tanks, and other organisations that bring people together for informal discussions of contemporary political-economic problems," insists Kapstein. That should include the accounting regulator too, I feel.

The first suggestion is that central bankers and financial supervisors "must speak more openly about the contemporary risk environment, and make clear what it is they do not know or understand." An essential `educative task', reasons the author, needed by all, "including households which are now facing a dizzying array of financial choices for everything from mortgages to investments to pension plans." Catch up with `Some Random Thoughts' of Dr Y.V. Reddy, and also his speech on the `Role of Accountants in Fostering Economic Growth', both delivered in January and available on www.rbi.org.in.

The second suggestion of Kapstein is dramatic. "Central bankers and financial supervisors should contemplate playing `war games' or engaging in crisis simulation exercises not only with other government agencies, but with parliamentarians, members of the banking community, and other financial intermediaries as well." Why? As help in revealing systemic strengths and weaknesses, says Kapstein.

"Gower is a good captain, and is good knowledge and literatured in the wars," is a line from King Henry V that may well fit our Guv too! "Your faithful service and your toil in war," is what he'd demand of his deputies, as in King Henry VI. Well, "Whiles lions war and battle for their dens," it will be useful to remember this quote of the Bard: "the gentler gamester is the soonest winner."

Next, Kapstein advises "parliamentarians, who are concerned with financial stability" to meet, just as "central bankers and financial regulators meet regularly in places like Basel". He believes that such meetings "would make a positive contribution to greater appreciation of financial interdependencies, of risks, and of the need for collective action during crises." A suggestion, I'm sure, would find immediate takers from our elected representatives.

"Fourth, central bankers and financial regulators must continue to work with elected officials on the sorts of institutional reforms within their home countries that could contribute to greater stability," and fifth, work on "changes in regulation that will be needed in light of the potential risks posed by new market developments," taking into account Basel III changes.

"One of the great `successes' of financial supervisors over the past thirty years," according to the paper, is the de-politicising of the systemic risk environment and the transformation of crisis management into a technocratic exercise. Financial shocks have thus been somewhat easier to manage, "by reducing the number and type of players involved in decision-making."

In future, however, crises may make "greater demands for highly political responses that would involve active intervention by national legislatures and parliaments, alongside financial supervisors and central bank governors," foresees Kapstein.

"It is therefore critical that legislators and publics be educated about the contemporary risk environment, before the next crisis occurs," urges the author. Because, "as economic globalisation advances, the fundamental role of domestic politics in stabilising financial markets becomes increasingly apparent." Or, should we read it as destabilising?

The bittersweet sixteen

A case that's raging on in courtrooms is about FAL Industries and Forbes Gokak. "During a corporate amalgamation should the assets of the two amalgamating companies be valued at the market rate? When does Accounting Standard (AS) 14 issued by the Institute of Chartered Accountants of India become applicable — prior or post amalgamation?" asks Venkatachari Jagannathan in an article dated February 20 on www.domain-b.com about the case in progress.

At the core of the dispute is the basis of valuation of FAL's land measuring about 16 acres in Perungudi. Should it be considered at book value, which is said to be Rs 13.33 lakh, or at market value? Adding to the difficulty are valuation opinions from different accounting firms. Watch this space for more!

AccountSpeak@TheHindu.co.in

D. Murali

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