'Capitalism without failure is like religion without sin,' stated a famous American economist / historian while analysing the causes and consequences of the many financial crises in that country, nay even the world.

To be sure, that statement was not intended to provide an alibi for the excesses in the financial sector in years past. Nor is it an excuse for the buccaneering ways of Wall Street in recent years which have landed even the global economy in a serious crisis now. It was only a matter-of-fact expression of opinion from an economist who passionately believes that periods of euphoria and panics in the financial system are inherent features of a market economy and further that they are the cost that has to be paid for the benefits of a market economy - long-run increases in the standard of living which other systems have failed to deliver. In a sense, the opening statement is quite like Winston Churchill's famous quote that democracy represents the least evil solution in relation to other forms of government / other ways of organizing societies.

The philosophical foundations of free markets with minimal government intervention, have indeed been questioned very seriously by the real economic damage caused by the yet-to subside global financial market crisis. In this context, fundamental issues like how free markets should be, what should be the role of government, how discreet or how intrusive should regulation / supervision be - are all questions which have become extremely relevant in the western economies – particularly in the US and the UK.

Robust middle path but still scope for improvement

Those questions, though, have not become that prominent or relevant in India and in many other emerging market economies. For, India and many other EMEs did not go to the extremes in financial sector liberalisation in the past 10 years but have continued to chart out a middle path marked by many distinct features. For instance, significant state stakes in and control of the banking system, limits and tabs on the level of overseas borrowings of the banking and non-banking sectors, limited room for foreign capital in domestic currency and bond markets, the relatively unimportant role which non-core banking activities such as proprietary trading, structured finance and capital market activities have in the overall business plan of India's major commercial banks (the public sector banks), the historically longer time it has taken and (still takes) in India to introduce novel financial products which can multiply the level of risks in financial institutions' balance sheets - among others.

While many of the features listed above have been consciously designed by policy makers, it is also a fact that many other features of the Indian financial system have been obtained more by chance than by design. But, whether by design or by chance, it is a fact that there has not been a total breakdown of trust, confidence and credibility of the banking system in India and other EMEs unlike that in the major western economies such as the US and UK. The middle path, therefore, has remained robust.

While robust, it is also a fact that the global financial markets crisis has afforded countries such as India a unique opportunity to fine tune and improve their financial markets structures, institutions, instruments and practices.

That is, while the financial markets crisis is now pushing the free market economies towards a greater balancing between free market forces and official regulation / control of the markets, no such significant shift in policy is required in the EMEs. Rather, it may be advisable for such EMEs to go slow on further opening up of the financial sector or in adopting certain institutional practices / products and instruments of the west which have led to this breakdown in their financial systems. The lessons of the global crisis may instead be employed by countries such as India to fill the gaps in their financial infrastructure.

Areas for fine-tuning…

Three key messages or lessons which can be gleaned from the global crisis and which can be applied in framing our financial sector policy / for improving the effectiveness and efficiency of our financial infrastructure going forward are as follows:

a. Large, complex financial institutions are prone to significant loss of control and failures which can even have systemic adverse effects. 'Too big' has indeed failed. There is a significant message here for many of our policy-makers who seem to feel that India has to create some large, complex banks (by merging some of the large public sector banks) which can be 'competitive' on a global basis. These policy-makers seem to believe axiomatically that big is better. But they may well have to undertake a serious re-think on this issue.

Big need not be better

Concentrated banking and financial markets (through the creation of large, complex financial institutions) mean that aproblem or crisis in one financial institution quickly becomes a system-wide issue. On the contrary, the diversification of the financial intermediation activity among different types of institutions and numerous firms within a class of institutions could provide much greater systemic stability since the failure of one or even many firms would not endanger the entire system. Other firms can take the place of the failing firms. Indeed, the thinking in the western world is now moving towards even breaking up large complex institutions and creating the necessary legal framework to ensure that such 'behemoths' do not rise again. The importance of different types of financial intermediaries – commercial banks, non-banking financial institu-tions, micro finance institutions, regional and local banks, etc. in India, in this environment, cannot be wished away at all.

b. Improving the efficiency and effectiveness of the (monetary) policy transmission mechanism should be a key action point for our policy-makers. To put it in simple terms, how to ensure a smooth passing on of the interest rate moves of the central bank of the country to the ultimate savers / borrowers so that their savings / investment / consumption behaviour are suitably altered. It is important to note that time lags in the policy transmission has been (was) a given even in the western markets before this crisis broke out. It has just got more important to fine-tune this mechanism in the wake of the financial market crisis and the serious disconnect which has developed between central banks' interest rate stance / actions and the actual interest rate decisions of the private sector. The relatively muted reductions in commercial banks' deposit / lending rates in the past 6 months even as the Reserve Bank of India has effected significant reductions in its reference interest rates / created liquidity clearly show the frictions in the policy transmission mechanism.

c. Another key message flowing from the financial markets crisis is the critical need for better maturity matching of the balance sheets of financial institutions. In the housing finance market (the fountainhead of this crisis), for instance, policy-makers in EMEs such as India have to devote serious efforts towards developing some long-term liability products - that is, long-term and dedicated liabilities which can be used to fund long-term real estate assets such as residential mortgages. Such dedicated long-term liabilities straightaway go to providing better maturity matching and vastly reduce the interest rate risks for the lending institution. The incentive to securitise loan receivables is weakened in the process. Indian policy-makers, in this backdrop, have to seriously think of concepts like 'covered bonds' which can provide greater stability in long-term financial intermediation.

It’s someone elses baby after securitisation!

It should be remembered by policy- makers that securitisation of long-term loan receivables (originally funded by short-term money), though a good and even workable concept with proper regulation, has been one of the prime causes of the spread of this crisis to wide geographies instead of being quaran-tined to the (original) lending institu- tion. Loose or even absent regulation has been the cause of this diffusion of credit risk to institutions far and wide. The ability to securitise, in turn, reduced the incentive for the lender to practise sound underwriting of loans in the first place. Why should the lender do much of credit risk analysis if he can just parcel out the loan to the wider market and thereby eliminate credit risk from his balance sheet? It is someone else's baby after the securitisation!