Lessons from the Sub-prime Crisis
[Submitted by CA Praveen Chopra
March 25, 2008
Sub prime crisis is seen as an ugly incident that has dealt a heavy blow to the investors’ confidence, spelling doom on the securitisation markets across the world. Sub prime is a small segment of the US financial market where a series of defaults created a spill over effect of such magnitude that it has affected financial markets across the globe. This crisis provides salutary lessons for the Indian securitisation market. It highlights the importance of transparency and accountability. It also undermines the need for providing an effective legal framework to restore lost confidence.
Disclosures in Indian securitisation market are inadequate. It is desirable that RBI issues guidelines prescribing prominent disclosure of all risk factors associated with security receipts in issuance documents (similar to disclosures required for public offerings). This will reduce asymmetric information and thereby lower heavy dependence on ratings.
Securitised items find only a passing reference in the Annual Reports of banks and financial institutions which gives them an opportunity to dress up their financial statements. It is desirable to insert a ‘Statement of Risk and Exposure’ in bold letters in the financial statements clearly explaining exposure to various financial instruments along with the associated risks. Making such disclosure mandatory will make the financial reporting more accurate and reliable.
It is not only the banks but also the credit rating agencies who are widely blamed for the crisis. Their failure is partly attributed to sharp practices and partly to complexity involved in pricing risk. RBI should actively consider setting best practices for such agencies. But more importantly, we need to spearhead ongoing research with premier institutes for refining models of pricing risk; especially the risk in complex financial products. This will reduce subjectivity, consequently, reduce frauds.
This crisis also underscores the need for a vibrant secondary which is virtually non- existent in India. The responsibility is cast on RBI to take special efforts to create deep and liquid secondary markets with restricted players like the money market. Intermediated exchange for credit derivatives would negate counterparty risk which will curb ripple effect arising from defaults.
We need to take cognisance of the crisis and the lessons it have taught us. Aforesaid steps can greatly assist us in creating a robust financial infrastructure which will ensure healthy and sustainable growth of this market, provided we act quickly.