Financial Crisis | In an interconnected system, scale of exposure is secondary

Given the financialisation of the economy, one can never rule out that a non-financial entity will not lead to a financial crisis, especially a large non-financial entity

The Hindenburg Report on the Adani Group has not just rocked Indian markets, but also Indian politics. Parliament was disrupted with the Opposition raising questions from the government. The sequence of events has led to assurance statements from the government, the Reserve Bank of India, the Securities and Exchange Board of India, and so on. The Supreme Court has joined the action by constituting a committee to understand the events.

The assurances from officials stress that it is a one-off case, and the entire system remains robust. The RBI Governor in the February policy said: “So far as the Indian banking system is concerned, the strength, the size, and the resilience of the Indian banking system are now much larger and much stronger to be affected by an individual incident or a case like this. The banking system is strong.” The assurances from finance community are that the exposure of the Adani Group is a very tiny share of their balance sheet. The State Bank of India and other banks say their exposure is less than 1 percent of their respective books. The Life insurance Corporation has also puts its exposure to similar percentage. LIC Chairperson expressed optimism on meeting the Adani Group.

While all these comforting statements are needed to calm the stock market, they miss an important point. It is not so much whether a bank or a financial entity has enough exposure to a troubled entity, but how connected is the entity’s exposure to the overall financial system. In the last 15 years, we have seen two major crises which highlight how the interconnectedness of the financial system can pose problems for financial stability.

In 2006, concerns were brewing over losses in US subprime housing market. The prime housing market catered to those with good credit history, whereas the subprime housing market catered to people with poor credit history. The idea behind the subprime market was to promote house ownership in United States. The share of subprime mortgage loans to total loans of the banking system was around 5 percent of the total loans, and 8 percent of total assets of all commercial banks and savings institutions. Then Federal Reserve Chairperson Ben Bernanke while reviewing developments in the subprime market, remarked “we believe the effect of the troubles in the subprime sector on the broader housing market will likely be limited, and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.”

The rest as they say is history.

The subprime crisis not just became a major global financial crisis in the US, but also became a global financial crisis. Bernanke in a 2010 testimony to the Financial Crisis Inquiry Commission, called the subprime market losses as the major trigger for the eventual global crisis. The financial system was highly interconnected. The financial institutions had backed their subprime exposure by borrowing over short-term, which required constant rolling of the debt. As the crisis spread, it created liquidity problems leading to freezing of major parts of the financial system. The US Federal Reserve had to not just pump liquidity in markets but also design specific liquidity programmes for select entities such as fixed income mutual funds, primary dealers, etc.

A similar history played out during the Greek sovereign debt crisis in 2010. Greece was a small economy and initially it was unimaginable that the crisis will engulf entire Europe and rest of the world. The share of Greek debt in overall debt held by Euro-area countries was 4 percent. However, just like the subprime crisis, the Greek debt was held across financial institutions. The assets were backed by short-term borrowing, which led to similar vicious loop as in the case of subprime crisis. Given the institutional constraints, the European Central Bank could not provide liquidity like the US Federal Reserve, and this compounded the problems for European economies.

Both the episodes highlighted the importance of looking at the impact of an economic shock not just on individual financial organisation but on the interconnected financial system. The financial regulatory policies were micro-prudential which focused on the individual organisation. The policy toolkit was expanded to include macroprudential policies, which analysed the impact of the shock on the entire system and made policies accordingly.

The Too-Big-To-Fail became a serious issue where financial firms can grow so big that they cannot fail. Despite these developments, it is difficult to rule out a crisis as financial systems have become highly interconnected. In England last year, an abrupt change in fiscal stance of the government led to a crisis in a small segment of the financial market, named Liability Driven Investment (LDI) funds or pension funds. The central bank had to intervene to prevent the spread of the crisis to the wider market.

As this article is being written, there are fears that another local bank crisis could become a global crisis. In the US, a bank named Silicon Valley Bank (SVB) failed over the weekend. The bank looked fine on March 8 Wednesday but failed by March 10! The SVB is the second-largest bank to have failed in US history. The US Treasury, Federal Reserve, and Federal Deposit Insurance Corporation issued a joint press release addressing how the depositors will be paid back. The markets are worrying whether the failure will lead to yet another global crisis. We are seeing stock markets decline across the world and it must be seen whether this will spread to other financial markets.

The lessons from above are that the Indian regulatory system and bankers should not just sit back given limited exposure. The scale of the exposure does not matter in today’s interconnected financial world. However, a large non-financial group can make the entire financial system fragile in no time. The Hindenburg Research-Adani Group crisis started with equity markets and posed concerns for banking and insurance markets. Thankfully it did not spread like the subprime and Greek debt crisis as the group is not a financial company and as a result it is not as interconnected as a typical financial unit. But then given financialisation of the economy, one can never rule out that a non-financial entity will not lead to a financial crisis, especially a large non-financial entity.

The Hindenburg report is about one company, but has highlighted many gaps such as: lack of short-selling opportunities in India, nature of stock market research in India, corporate governance, etc. Like all the crises, this one too provides an opportunity to relook at the financial system, identify its weaknesses, and address the gaps.

(Amol Agrawal is an economist teaching at Ahmedabad University.)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.