Macro economic policy, particularly policy relating to foreign capital flows, exchange rates, whether primacy should be given to inflation control, what should be the role of the central bank in ensuring stability in the financial system, how intrusive should regulation and supervision of financial markets be and how can that be married with the need for continued financial innovation, how rigorous should fair value accounting be and whether it should be mandatory even during a period of severe financial market stress, what changes are needed in the compensation and incentive structure in the financial markets business given that it has been driven, till recently, by a focus on short-term profits only - these are among the weighty issues which have been sharply highlighted by the financial crisis which originated from the burst housing bubble in the US.

It is a safe bet that on many of these issues, far reaching and fundamental changes will come about during the course of the next couple of years. Important segments of the financial services industry and financial markets - for example, the over-the-counter market in derivative instruments such as credit default swaps - which have hitherto been outside the purview of formal regulatory oversight on an on-going basis, will most likely come under formal regulatory control. The OTC market in derivatives would have to be integrated with the systemic benefits provided by the clearing / settlement and guarantee mechanism of the organized exchanges.

It is poignant to note here that only if US policy makers (the Treasury and the Federal Reserve) in the late 1990s had heeded the warnings of one of their own (the head of the Commodities Futures Trading Commission) to bring the OTC derivatives markets under regulatory control, the collapse of AIG, till recently the world's biggest insurance firm, may well have been avoided. AIG became insolvent primarily on account of a huge amount of credit guarantees (> $ 400 billion) it had provided through the mechanism of credit default swaps to the holders of mortgage-backed securities. These contingent liabilities had to be taken on the balance sheet as real liabilities once the housing bubble burst and mortgage-backed securities became worthless assets.

Impact at more micro level - The case of the OTD business model

Be it as it may, it can be seen that the issues listed above as having been highlighted in the crisis are primarily macro and of a systemic nature. It is interesting, in this backdrop, to note that the financial crisis has also thrown up a number of pointers to business development at the micro level.

In commercial banking, for instance, the severe credibility crisis the originate-to-distribute (OTD) business model is suffering from now is an extremely important signal to re-formulate business strategies. This likely presents an opportunity for traditional and conventional banks to build on their core competencies and thereby strengthen their competitive position.
It is a fair guess that the OTD model (where loans are originated by a lender and are almost simultaneously packaged and sold off in the broader capital markets through the instrument of securitization), at least for assets such as vehicle loans, personal loans, credit card receivables etc does not recover at least for the next couple of years.

Not only has the concept and instrument of securitization been abused to the point where it has lost its credibility. The downturn in the economic cycle is a factor (though macro) which can result in a deceleration in the growth of primary loans / assets themselves in banking balance sheets. (In India, though, we have not yet seen the full economic cycle impact as credit growth in the banking system is still robust - growing at close to 30 per cent y-o-y, despite the much talked about credit crunch, though it has to be also pointed out that specific segments such as retail lending / credit cards have seen a notable deceleration).

As a corollary to the severe strains on the OTD model (if not its demise altogether), the traditional / conventional banking model will strongly gain in importance and market share. The concepts of relationship banking and portfolio lending - where loans are made and banking relationships are built mainly on the basis of extensive information sharing between the borrower and lender, where loans are even customized to suit borrower requirements (as against the OTD model which churns out standardised and templated loans (such as two wheeler loans, credit card loans etc) and where loans are carried on the balance sheet of the lender invariably till maturity will re-assert its importance and will likely become a dominant theme going forward.

It is again a fair assessment here that those banks which have the ability to carry loans till maturity on their balance sheets - which implies that such banks have diverse, stable and competitive funding sources - will likely gain market share at the expense of other banks who may not have such an ability.

The criticality of the branch network

In this context, it is interesting to note the latest move by State Bank of India, the Indian market leader, to open as many 2000 additional branches during the course of the next couple of years. This is a business strategy which builds on the inherent strengths of the State Bank group - its access to large, diverse and stable funding sources and its ability to do large amounts of portfolio lending and relationship banking.

State Bank did not take recourse to (and also did not feel the need to given its inherent strengths mentioned above) the OTD model in the past many years. Now, in the wake of the financial crisis and the extreme stress on the OTD model, SBI seems well positioned to capitalize on its inherent strengths and on the weaknesses of its competitors to increase market standing and share. (To be sure, State Bank and other public sector banks despite their strengths in the traditional business model, will nevertheless, continue to reckon with the strategic constraints which public ownership imposes).

Widespread and a well distributed branch network is another concept which has become hugely important for being a viable commercial bank in the wake of the financial crisis. That is, it is back to brick-and-mortar banking in a major way.

State Bank's emphasis on opening as much as 2000 branches - as pointed out by the SBI Chairman, this is even more than the total number of branches of many banks itself! - is a clear pointer to how critical a large and strategically positioned branch network has become. It is such a network which provides access to the relatively lower cost and stable funding base which commercial banks are desperately seeking out now.

Internet banking and alternative delivery channels such as ATMs and mobile banking etc, may correspondingly have reduced emphasis going forward. These concepts have their roles to play too, but in the overall scheme of things, these are not the factors which can either ensure a bank's survival or render it insolvent. A wide branch network and access to retail business on both the liability and asset sides of a bank balance sheet, though, is something which is absolutely critical to a bank's very survival. One just needs to ask Citigroup, Bank of America and JP Morgan Chase for proof.

Small continues to be relevant and good

Another very significant message from the financial crisis is that smaller banks and financial institutions continue to be critically relevant in the overall system. This issue needs to be dealt with more elaborately but suffice it to say that being big has not really guaranteed stability, safety, prudent business practices and, last but not the least, integrity in business practices. The 'banking consolidation and getting bigger' bandwagon in India will likely slow down in the wake of the crisis and justifiably so.