Despite the availability of Government bail-outs for public sector banks, a crisis situation may develop if things don’t change. Message has to be sent to bank managers to behave and corporate entities to repay
Now that Vijay Mallya has returned to the headlines, it is important to turn to a question that did not receive adequate attention while the storm raged. What does the entire episode reflect in terms of capitalism and its legitimacy, and the country’s prevailing economic systemIJ Mallya borrowed, allegedly on terms that should never have been given, and has not repaid much of it. He has not paid salaries to a section of his employees and, allegedly, been a tax-defaulter. It is hazardous to judge a system by an individual’s conduct and competence. But for the massive recession that began in 2008 and is considered only second in its severity to the Great Depression that began in 1929, one would have regarded the Mallya episode as yet another of the many controversies that bedevil most countries’ economies. Also, the system he manipulated so brazenly, no doubt with the full complicity of those who did not protect its integrity which they should have, has been showing signs of pervasive corruption for a long time.
An important common element in the 2008 crisis and the Mallya scandal is reckless lending by banks. In the case of the latter, it has led to a massive accumulation of outstanding loans to the tune of thousands of crores of rupees. In the case of the former, it led to a meltdown of the American economy which then travelled to the rest of the world, spreading havoc. The question arises whether reckless lending can undermine this country’s banking system, pushing the entire economy is into a crippling recession.
One must start by examining the causes of the 2008 crisis. At the root of it was an enormous housing bubble fuelled by mortgage deals that offered alluringly low interest rates at the beginning but had built-in provisions for their subsequent steep increase and repeated refinancing, requiring high fees to be paid at every stage. Mortgage dealers deliberately went for the poor and poorly-educated Americans who, like most of their compatriots, longed to possess their own homes. Many of the victims, who came to be called sub-prime borrowers because they had low and/or irregular incomes, were unable to detect the hidden dangers; some, who expressed doubts, were disarmed by false assurances.
These were high-risk loans which Wall Street, the banks and their executives blinked at in fact, encouraged not only because of the provisions for steep interest escalation but because they securitised the mortgages, repackaged them in many ways, and sold to one another and banks and financial institutions outside the US, making large profits at every step. And high profits meant high bonuses and pay hikes.
Joseph Stiglitz, who exposes all this with remarkable clarity in Free Fall: Free Markets and the Sinking of the Global Economy, writes, “Indeed, many of the new ‘innovative’ products based on mortgages had some critical features in common: while they may not have helped borrowers manage risk, they were designed to shift as much risk away from the bank as possible and to generate as many fees as possible-often in ways that the borrower was never really aware of. The products were also designed, where necessary, to get round regulatory and accounting restraints that might restrict lending and risk-taking.”
The bubble was bound to burst sooner than later because many people could not pay the rising interest rates and recurring refinancing fees built into their mortgage agreements. The process was accelerated by declining prices of houses following glut of new ones. The result was payment defaults and foreclosures. The effect of the bubble’s collapse was disaster on a national scale because, as Joseph Stiglitz puts, the US economy “was out of kilter: two-thirds to three-quarters of the economy (GDP) was housing related: Constructing new houses or buying contents to fill them, or borrowing against old houses to finance construction. It was unsustainable-and it wasn't sustained. The breaking of the bubble at first affected the worst mortgages (the sub-prime mortgages, lent to low income individuals) but soon affected all residential real estate.”
Crookedness was doubtless an important cause of the crisis. As Stiglitz says, “The wheeling and dealing of the mortgage industry in the United States will be remembered as the great scam of the early twenty-first century.” Mortgage originators, however, were not the only guilty ones. At least as culpable were Wall Street companies which, besides exploiting the borrowers, had innovated financial instruments that “had allowed the banks to hide much of their bad lending, to move it off their balance sheets.”
Crookedness, however, does not thrive in a void. It requires an environment that condones if not encourages it and provides those so inclined to resort to it with at least some measure of impunity. A system that places profit maximisation above all else, including ethical conduct, and lacks regulatory mechanisms that can keep delinquents and delinquent and reckless banking practices in check, provides a fertile soil for it. The US, as Stiglitz points out, had a fairly effective regulatory system in place until the 1980s, which witnessed its systemic whittling down under the Reagan presidency. The process continued in the 1990s and the first decade of this century and did not spare even provisions for restricting predatory lending in the sub-prime sector.
All this was the result of an economic approach that celebrated the sovereignty of the market, ascribed to it powers of self-correction, and of ensuring stability for the economy and prosperity for the people. Regulations were regarded as unnecessary obstructions that only hobbled the economy. The crisis has discredited this ideology which has been described as market fundamentalism. But its proponents continue defending it blaming the crisis on individual delinquency, an unforeseen accident and so on, overlooking the fact that delinquencies require opportunities to create havoc and the numerous crises that have occurred till date debunk the idea of an accident.
In India, money had been lent not to sub-prime borrowers but corporate giants who have defaulted. Sound banking practices have not been followed whether due to political pressure or corruption among bank officials. Despite the availability of Government bail-outs for public sector banks, a crisis situation may develop if things do not change. A message has to be sent to bank managers to behave and corporate entities to repay. It would be more difficult to insulate banks from political pressure to sanction bank loans.