For all the like-never-before-and-hopefully-never-after financial, fiscal, economic and social costs of the Global Financial Crisis, the one perverse benefit of it, nevertheless, has been that it has had the focussed attention of global law and policymakers, and head honchos of the finance and banking industry. Also, like never before, it has compelled a cathartic reappraisal of how risk should be defined and measured.

As someone has famously said, what you cannot see, you cannot measure and what you cannot measure, you cannot manage. For such is the insidiousness of risk that its under-pricing is perceived as low, or no risk, and, therefore, policymakers, regulators, supervisors, economic agents, including banks, business and industry, are caught unawares and blind-sided when risk suddenly eventuates.

Identifying risks

Systemic risks in global markets can be best identified and measured by looking at some select key parameters which, between them, indicate the extent of asset bubbles and the corresponding under-pricing of risks and, therefore, it is not so much high volatility, which is the “effect”, that should be a cause for concern, as persistent and excessively low volatility, which is the “cause” and was the hallmark of the pre-crisis period.

In particular, it is very instructive to look at the readings on parameters such as (i) TED Spread (3M LIBOR – 3M Treasury Bill), (ii) 3M LIBOR – 3M OIS, (iii) 3M LIBOR – Effective Fed Funds Rate, (iv) VIX Index; and (v) CDX Crossover Index.

Pre-crisis, these were at historically low levels. This was the time when there was a veritable bubble across credit and equity markets and global policymakers were already warning about huge under-pricing of risks in the run up to the crisis.

But unfortunately, nothing, in terms of pre-emptive, proactive and credible policy response, other than these warnings, was delivered. If one looks at the recent readings, there is incontrovertible evidence that there is yet again a huge under-pricing of risks in the financial system and, therefore, it is not a question of if, but when, generic asset bubble caused by manifold increases in balance-sheets of central banks will burst.

Specifically, currently the global liquidity has become a bigger concern than it was in the pre-2007 period what with ultra-low and near-zero policy rates and major central banks' balance-sheets 1.50 to three times their pre-2007 levels, adding about $4 trillion in incremental central bank liquidity.

Worse, US banks are reportedly keeping excess reserves of $1.5 trillion with the Fed rather than lend to small businesses and households. Alongside, non-financial corporations in the US are reportedly sitting on cash and liquid assets worth $2 trillion which they do not know what to do with.

Asset bubbles inflating

In this background of huge deluge of global liquidity, there are unmistakable signs of asset bubbles inflating again in almost a replay of the last global financial crisis. As of January 27, 2012, the overvaluation of gold — what we can also call gold bubble — with reference to seven competing asset classes varied from 78 per cent against highly correlated metal prices proxied by LMEX, 62 per cent against WTI crude, 109 per cent against US Treasuries proxied by JP Morgan index, and roughly 230-275 per cent against Credit Default Swap Index, Dow Jones, the US dollar index DXY and the US home price Case-Shiller index.

There was already significant risk that the monetary policy environment of very low interest rates and unprecedented deluge of liquidity may yet again engender another bubble in the not too distant future.

And, indeed, we almost had a commodity bubble which, to all intents and purposes, was caused by this very huge deluge of liquidity but burst due to the enveloping global economic downturn, in general, and countercyclical measure of NYMEX raising cash margins on crude oil futures and CFTC checking speculative positions, in particular.

Again, we are heading towards another bubble, shades of which, contextually, we experienced recently on August 4, 2011, and post FOMC meeting on September 20, 2011, when crude oil and global stock markets slumped by around 5 per cent and gold, after touching an all-time-high slumped to $1,530 per troy ounce on the Chicago Mercantile Exchange raising cash margins on gold futures by 20 per cent. Perhaps, if this swamp of liquidity and monetary easing are not unwound appropriately, and in an orderly and timely manner, the next crisis might well be a veritable “financial and economic nuclear winter.”

Addressing the ‘cause'

As regards prevention of the building up of such systemic risks, the answer is addressing the ‘cause' and taking appropriate sector-specific, countercyclical macro-prudential measures, pre-emptively, decisively and proactively, rather than reactively.

Specifically, based on the financial parameters for detecting asset bubbles and under-pricing of risk, some of the sector-specific countercyclical prudential measures are selectively increasing capital charge by increasing risk weights for asset classes where bubbles exist, or, are in the process of building.

These measures need to be complemented by fixing the maximum absolute leverage at entity level (not allowing for risk weights for assets). Contextually, it is instructive to note the comments of the legendary investor Mr Warren Buffett who, contemporaneously with the rollout of Basel I in the late 1980s, tellingly remarked that he did not like banking stocks where assets were 20 times equity, translating into common equity to total assets ratio of 5 per cent, which is roughly 1.67 times the Basel III prescribed minimum common equity to total assets ratio of 3 per cent (leverage of 33.33 times).

Be that as it may, these regulatory measures obviate the need of monetary policy tightening which is a blunt tool indiscriminately affecting all sectors of the financial markets and the real economy, although, significantly, monetary policy can also be deployed alongside as a complementary companion tool to credibly and effectively address the build up of systemic financial risks.

But unfortunately this broad-spectrum and generic failure of an inertial regulatory and supervisory system worldwide, especially in the West, precipitated the unprecedented global financial crisis. The most no-holds-barred acknowledgement of this, though it came much later only recently, was when Mr Donald Kohn, former Vice-Chairman of the US Federal Reserve apologised by saying, “The cops were not on the beat, resulting in the worst economic recession and loss of millions of jobs.”

Besides, significantly, the credit crisis has also thrown into sharp relief a “strong connect” between “liquidity risk” and “opaque off-balance-sheet exposures” of whatever description. The appropriate supervisory and regulatory response to these risks would, therefore, be to insist on full disclosure and transparency of off-balance-sheet commitments/exposures and supervisory insistence on an appropriate mix of “stored” and “purchased” liquidity and appropriate capital charge for liquidity risk; the higher the “purchased liquidity” component, the higher the capital charge and the higher the “stored liquidity” component, the lower the capital charge.

‘Prudential measures'

In refreshing contrast, in India, we have had remarkable financial stability, not fortuitously, but thanks to pre-emptively and proactively delivered counter-cyclical prudential measures such as increase in risk weights for exposures to commercial real estate, capital market, venture capital funds and systemically important non-deposit accepting non-banking finance companies (NBFCs).

These pre-crisis prudential regulatory measures of Reserve Bank of India represented what now are famously known as ‘countercyclical prudential measures' and have been strongly commended for adoption by various recent Working Groups / Committees of international regulators.

Indeed, in the aftermath of the global financial crisis and resulting economic recession, these countercyclical prudential measures were rolled back to cushion the adverse impact of the crisis to considerable beneficial effect to the Indian economy.

Not only that, in equally refreshing contrast, post-Basel II, the Reserve Bank, unlike in the West, did not allow banks in India to reduce their capital and prudentially mandated that banks continue to hold the then existing absolute capital. As a result, we, in India, are in a happy situation where banks have a common equity to total assets ratio of more than 7 per cent which is already ‘more-than-twice' Basel III compliant on this critical parameter. Significantly, recently again, to contain potential systemic liquidity risk, the Reserve Bank has capped banks' investments in Fixed Income Mutual Funds to 10 per cent of their net worth.

Additional terms

In my considered opinion, the famous Taylor rule can be modified suitably to include, alongside inflation and GDP, additional terms representing systemic financial conditions based on the financial parameters for detecting asset bubbles and under-pricing of risks. Although, while for now this challenge is a work-in-progress for me personally, I would strongly encourage discerning researchers to pursue and take this idea forward.

To sum up, at the end of the day, the problem is not knowing the problem, but knowing it and dithering, agonising over choices, temporising, procrastinating and doing nothing credible, timely, tangible and decisive about it.

In other words, paraphrasing John Ruskin, what finally matters is not knowing what must be done but actually doing what must be done and doing it when it must be done.

Genesis of the crisis

The recent financial crisis has thrown into sharp relief, as never before, the critical and important role of ‘asset price' inflation/asset bubbles too, as opposed to that of shop-floor/products/services inflation alone, as a key variable in monetary policy response.

For what happened was unprecedented in that with monetary policy focussed only on traditional CPI, interest rates were kept low in spite of exploding prices of assets such as real estate/property, credit assets, equity and commodities.

And this was all made possible because of huge current account surpluses in China and other EMEs (emerging market economies), and huge private capital inflows into EMEs in excess of their current account deficits, getting recycled back as official capital flows into government bonds of reserve currency countries, especially the US, resulting in compression of long-term yields which, in turn, translated into lower long term interest rates even for the riskier asset classes mentioned above.

Credit bubble

This chasing of yield, due to global savings glut, in turn, led to a veritable credit bubble, characterised by unprecedented under-pricing of risk as reflected in the all-time-low risk premia with junk bond spreads becoming indistinguishable from investment grade debt, and thus, to paraphrase Jim Grant, the riskiest of assets effectively offering return free risk.

All this while, the US growth story stayed non-inflationary due primarily to cheap imports from China, Asia and EMEs which, only perversely, reinforced the continuation of the loose monetary policy, focused, as I just said, as it was on the shop-floor-price inflation to the complete exclusion of the broader ‘asset price' inflation.

Such a low interest rate environment, coupled with luxuriant supply of liquidity, created enabling environment for excessive leverage and risk-taking so much so that American household debt exceeded the country's GDP.

In fact, in the US, in particular, the financial sector, instead of being a means to an end of sub-serving the real sector, ended up being an end in itself. This syndrome of too much of arcane rocket science and financial alchemy in the financial sector, almost entirely for its own sake to almost complete exclusion of the needs of the real sector, created a massive ‘financial sector — real sector imbalance' which, being, intrinsically unsustainable, culminated eventually into the now-all-too-familiar apocalyptic denouement, entailing cumulative global write-downs and credit losses aggregating $2 trillion by banks and financial firms.

(Edited excerpts of the Inaugural Address delivered at the World Risk Workshop 2012, organised by R-square RiskLab, in Mumbai on February 6-7. The views expressed by the author, an Executive Director of the Reserve Bank of India, are his own and not that of the RBI.)

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