Thirteenth New York Fed/NYU Stern Conference
In India, as in many emerging economies, one of the charges to financial market regulators is to protect investors in securities. This is typical done through some combination of increasing investor awareness, disclosure rules, ensuring the safety of financial transactions and addressing grievances. However, when financial scams occur, they are passed off as yet one more instance of crooked people making money and even as regulator failure. Given the frequency with which they make the headlines, it is hardly surprising that few Indians with an investing interest see long-term financial instruments like equities as deserving of their investible income. The purpose of this piece is to nudge potential market players towards a more balanced outlook on the various factors that enter this decision.
First, financial shenanigans occur in other, more developed parts of the world as well. For every complaint about Ponzi schemes like Saradha, there is a Bernie Madoff, who perpetrated a similar scheme for over two decades in the United States. Enron and Worldcom involved falsifying accounts just like Satyam. For every concern about the mis-selling of financial products like insurance and mutual funds, one can recall the events around the global financial crisis in 2008. Remember NINJA (no-income, no job, no assets) loans, and more recently, about 5000 Wells Fargo employees creating fictitious customer accounts to meet sales targets! There are scams without an Indian analogy too, witness LIBOR where major global banks colluded to set short-term floating interest rates to which several hundred trillion dollars of derivatives are linked. There was Jerome Kerviel, the Societe General derivatives trader who took exceptionally large bets. Whether there is a scam in the headlines or not, the familiar refrain among Indians with investible income (and even those with equity exposure) is that stock prices are almost always manipulated. This too has its parallels in the well-worn Wall Street adage that “prices do not move, they are moved!”
Is it that rich countries can afford to take a more casual attitude to scams? Is the impact much less in larger equity markets? The chart below shows the disputed amount in some of the above-mentioned scams as well as the size of the loss to the transgressing firm or to investors. Of course this short-term market penalty may be partly panic, itself victim to the theory that cockroaches are never seen in isolation and may even reverse itself thereafter. Still, a look at the relative magnitudes is instructive. Firm-specific accounting improprieties like Worldcom and Enron outside India appear to extract more severe short-term market penalties than the Satyam incident. However, Indian markets are much more roiled by violations traceable to individuals.
And what about regulatory responses? In the Indian chronology of scams, there are some common features among the Harshad Mehta incident of 1991-92, the Ketan Parekh scandal of 2001-02 and the more recent Nirav Modi brouhaha. The Bank receipts created by Harshad Mehta, the pay orders by Ketan Parekh and the letters of undertaking that Nirav Modi abused, are all essentially documents that offer a false bank guarantee with which funds can be raised for nefarious purposes. Regulatory responses like improving the SWIFT system amount to fixing “leaks” in the dam without addressing root causes. This similarity ranging over three decades- a period during which there were many “significant” changes in the bank regulatory landscape suggest that, at the very least, penalties levied for such transgressions did not deter fraudulent behavior. It is easy, even tempting to conclude that the repetitive nature of these violations represents a failure of financial sector reform. To be fair, regulators do not always drop the ball, indeed it is the very nature of financial innovation that they will almost always play catch-up.
However, one should also recognize that such situations cannot recur without the cooperation and willingness of employees to “bend” the rules. Particularly after the Global Financial Crisis of 2008, this conduct risk has come to mean ensuring the delivery of fair customer outcomes and the preservation of market integrity. Within the financial services industry, the lack of trust that employee misconduct generates has led to the development of procedures and processes to limit conflicts of interest, improve the accountability of the firm’s leaders and is being tied to the reputation of the firm. The Financial Conduct Authority of the UK authorizes, supervises and takes appropriate actions against firms offering financial services to the public. Some investor protection rules in India attempt to be forward looking, although we would prefer that they were more evidence based. SEBI’s efforts at better managing algorithmic trading and suggesting suitability guidelines to restrict excessive speculation in derivatives fall into this general category.
For consumers of financial services, this should provide some amount of comfort. The principle of caveat emptor (buyer beware) has long been at the centre of contract law and commerce in many jurisdictions. Caveat venditor (seller beware) is what the supervision of a broad range of activities under the umbrella of regulating conduct risk offers. Financial markets are risky places even without scams. What Indian investors should be focused upon are the risks emanating from the ebb and flow of the business cycle, from changing technologies and consumer tastes and from the rise and fall of market prices as individual businesses navigate them. As India moves over the coming decades towards a more middle -class economy, it is our view that the rewards to managing those latter risks will be quite attractive for those willing to stay the course.
S.G. Badrinath, Canara Bank Professor of Banking and Finance, and Chair, Centre for Capital Markets, IIM-B
and Vijay Sarathi, Senior Research Fellow, Centre for Capital Markets, IIM-B.
This piece represents the views of the authors.