US to Europe to India --- the Hurricane is on !

The cost of European rescues threatens to match the US rescue cost of AIG or Bear Stearns.
Clearly, European claims to good, prudent regulation — in supposed contrast with the US — are highly suspect. Investment banks like Lehman Brothers had leverage ratios of up to 30:1, and this was widely condemned as casino capitalism. But august European banks appear to have leverage up to 50:1 !

Crunch this : Ratio of bank loans/assets to GDP is astoundingly high at 623% (Kaupthing) and 374% (Landsbanki) in Iceland, 484% (UBS) and 290% (Credit Suisse) in Switzerland, and 290% (ING) and 121% (Rabobank) in Netherlands. As many as 14 banks have loans/assets exceeding the GDP of their respective countries. When such banks are rescued by governments, the creditworthiness of the governments themselves may be tainted. So the zero-risk weighting assigned by banks to government debt may be a potential time bomb. The risk premium on Iceland’s debt, for instance, has suddenly spiralled, notwithstanding AAA status. European banks use the risk weighting of the Basel norms, and justify their high leverage by pointing to the high quality of their assets (including much sovereign debt). Yet last week’s events carry three sobering lessons.

First, the highest-rated assets, even government debt, can get tainted in a crisis — at which point leveraged European banks could suffer devastating losses.
Second, in a panic, not even the biggest financial institutions are safe from a run on deposits or panic selling of securities.
Third, many practices — such as mark-to-market accounting and capital adequacy norms — are pro-cyclical, not counter-cyclical, and can worsen deadly downward spirals in a downturn.

In some ways, Europe has deeper problems than the US. European banks like Fortis typically have operations in several countries, and this complicates rescues. Fortis’ rescue entailed uncoordinated, partial nationalisation by three different governments. In the US and Britain, the government and monetary authority belong to same nation. But in the Eurozone, the European Monetary Authority is an independent institution, whereas the rescuers of banks are national governments. In the US, Fed governor Bernanke and treasury secretary Paulson can get together on rescues. In Europe this is not possible, and so adds to the risks there.
To remedy the problem, Sarkozy has proposed a joint European financial rescue pool, but Germany has said no. So, European co-ordination problems spell danger. Indeed, some fear that the Eurozone may fall apart under the coming strain. Many analysts say the problem started with the US housing bubble. Yet house prices rose much faster in many European countries, such as Britain, Ireland and Spain. Mortgage terms were more conservative in Europe, and that helped, but not enough to insulate lenders from crisis. The supposed contrast between Anglo-Saxon free-marketeering and European welfare capitalism has turned out to be mostly hot air. The two models have more commonalties than differences. Higher regulation has not crisis-proofed Europe. Many Indians are gleeful that US and European financiers, who lectured us during the Asian financial crisis on the virtues of western financial systems, now stand exposed as dummies themselves.

For all its shortcomings, the financial system looks safer today in India than in the US or Europe. But don’t celebrate. India has simply proved that if a financial system is bound hand and foot, it will not have enough rope to hang itself. Besides, the western financial crisis is going to dent Indian companies borrowing abroad for expansion and take-overs. Share prices have fallen way below the conversion price for $6.5 bn of foreign currency convertible bonds, and that spells big trouble when the bonds mature. The depreciating rupee is helping exporters, but raises the rupee value of foreign loans, leading to huge profit write-downs. A global recession has started and may continue for a year. This will hit Indian exports, production, interest payments, job expansion, and stock markets. Forget talk of decoupling: India is going to slide down along with the west. Even though our financial system is relatively insulated, our trade and economic systems are now integrated with the rest of the world. After the US, Europe is the next falling domino. Asia and India will soon follow. Ask not for whom the bell tolls: it tolls for thee !