Handling a crisis
The media attention in the recent stock market crisis has been on the juicy tidbits: scandal at the BSE, CSE; the personality of Ketan Parekh; malfunctioning cooperative banks; surgery at SEBI, etc. However, lurking below this has been a profoundly dangerous systemic crisis.
Systemic crises are truly frightening events, which every country in the world has to face. The environment of a market crisis is composed of (a) a sharp fall in prices, (b) impending bankruptcy by one or more large players with fears of payments crises, and (c) a sharp worsening of market liquidity.
Every player has a lot to lose in a systemic crisis, and the sad fact is that the uncoordinated responses of all players serve to worsen the crisis:
- The clearing corporation sees high price risk and poor liquidity, so the Value at Risk models at the clearing corporation require greater collateral. This comes at a time when all players are stretched at the limits of their leverage and are least able to fork up collateral.
- Naive investors (both retail and institutional) are often positive feedback traders; they believe that recent price changes will be repeated in the future. The depressing fact is that our financial industry has a large supply of poorly educated employees so it isn't hard to find such naive investors. Naive investors fear further price drops and rush to the exits. If there isn't a "sufficiently large" supply of smart investors who are on the other side, this generates further price drops.
- Banks find customers failing on margin calls for loans against shares portfolios, so their systems trigger off liquidation of collateral, which drives prices down.
- All banks nervously retreat towards "a smaller exposure to securities markets" : lower loans, lower bank guarantees, etc. Top managements at many banks call a halt to these activities pending a full review of risk management procedures. This hits leveraged market participants at a time when they need capital the most.
- All these actions serve to suck out liquidity (i.e. raise transactions costs) from the market. High transactions costs lead to lower stock prices through the liquidity premium, thus directly exacerbating affairs. Fears about an unreliable supply of liquidity make firms closeout positions and back away from trading, which hits stock prices.
The first question we should ask is clearly: "What is a superior market architecture which generates reduced vulnerability to systemic crises?" This is an important question, and a lot has been written about what can be done better - rolling settlement, novation at the clearing corporation, exchanges which are not run by brokerage firms, etc.
However, that does not eliminate systemic crises, which will take place. In order to cope with them better, we need a well thought out plan about how a coordinated set of responses will be put into play, so as to help matters where possible. Even more important, a well thought out plan, which is articulated and agreed-upon in peacetime, will diminish wrong reactions by policy makers which actually make things worse when there is an outbreak of war.
Liquidity, liquidity, liquidity. The first focus of policy makers should be to fight for low transactions costs on the market. The goal should be to stay out of the vicious cycle of a drop in liquidity triggering off a drop in prices, which feeds on itself.
SEBI got this wrong. Let us review the evidence. Liquidity is measured by "market impact cost", which reflects the cost of transacting. (Market intermediaries like to measure transaction volume, which directly feeds them revenues, but from the viewpoint of the Indian economy, we care about transactions costs and not trading volume). I will focus on the transactions costs involved in doing a trade worth Rs.5 million on the NSE-50 index on the largest exchange (NSE). This time-series (impact cost on the NSE-50 index on NSE) is the best measure of stock market liquidity in India.
Under normal circumstances, the impact cost for buying or selling Rs.5 million of Nifty is around 0.2%. Markets tend to become illiquid when there is price volatility, so in the period from 27 Feb till 7 March, this rose to 0.25% (a degradation of liquidity of roughly 25%). On 8 March, SEBI came out with the strange policy measure: a ban on "short sales". This sharply hit the liquidity of the market: from 8 March till 22 March, the impact cost was higher at 0.32, another degradation of roughly 25%. Thus SEBI and the market crisis take roughly equal credit for generating a sharp drop in market liquidity.
SEBI's ban on short selling was a clear failure of intellectual analysis. SEBI did not see that it's first role should be to protect market liquidity. Instead, it went by a silly argument that banning short sales helps obtain higher stock prices (it never does and it never will). The first thing that we can do to find our way out of this crisis is to reverse this ban.
Price limits can prove to be an important impediment to market liquidity: When a stock hits a limit, the securities market becomes completely illiquid, and economic agents become fearful through not knowing what the true price is. The existing price limit regime of 8% and 16% is basically a sensible one, but it would help to move that to (say) 12% and 24% under crisis conditions, to improve the supply of liquidity to the market.
Banking. There have been difficulties with certain banks, but the banking system as a whole is working fine, and the broad framework for prudential regulation with loans against shares or bank guarantees for brokers are quite fine. A lot has been written about how this crisis is like 1992, but it actually is not: in 1992, every major bank was party to the fixed income scandal. This time around, it is a highly isolated affair. Policy makers should be very careful to combine enforcement against fraud with an uninterrupted supply of credit from the banking system into the securities industry.
Avoiding a witch-hunt In recent weeks I have seen a witch-hunt gathering momentum, where we have investigators from SEBI, CBI, ED, IT, RBI poking and probing at market participants and at each other. We must be a law abiding country, and the people who have committed crimes should be punished. But in an atmosphere of a systemic crisis, it is important to be extremely controlled about it. Government should have a single team working with well defined goals, with no appearance of a witch-hunt. The longer that we have an atmosphere of a witch-hunt with market volatility in response to strange rumours swirling around, the longer it will take for economic agents to get back into comfortably participating on the market, and giving us sensible prices and liquidity.
In short, we have done a fairly poor job of dealing with this crisis, and we should learn how to do it better in the future. I have done this column for Business Standard from 1997 onwards, and for the first time, I will now venture to offer tangible investment advice: If you can be clear-headed about it, this is a great time to buy Indian equities, and you should buy up as much of the Nifty futures as you can.
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