Here is a verbatim transcript of CB Bhave’s address at the Hindustan Times Leadership Summit:


Let me begin with the problems that the world is facing today. In August 2007, the United States (US) and the European markets had discovered that their financial institutions were carrying on their books assets which came to be known as sub-prime assets of which they had no idea of how to value.

The whole thing came up when one of the banks in its quarterly report said, “I do not know how to value my book.”

That created a fear in investor’s minds that all these balance sheets and profit and loss accounts may just be a story and which required more reading into. They feared these numbers did not reflect the actual state of affairs.

After August 2007, till January 2008 Indian market kept booming. So a theory developed around that time that we were decoupled from the Western economies and India was relatively in isolation and would charter its own cost.

Our focus of attention was essentially on the stock markets. Then the market had some shocks in January then saw some recovery and in subsequent months saw a fall again and so on. Till September 15, when one of the biggest US financial institution, Lehman Brothers was allowed to go bankrupt, we had not realized how closely linked with the world we were.

Even on September 15 indian did not realize the profound effect it would have on the economy. Interestingly even the Western regulators did not see this recession.

This effect was not on the stock markets, the effect was on the credit markets.

One of the things we probably missed out is the importance of credit markets in the world.

As Lehman went down – there was already this fear for a period of one year in the minds of investors of whether balance sheets portrayed a true picture of the bank properly or not. Then, another peculiar thing happened i.e. institutions stopped trusting each other.

So if a bank doesn’t trust another bank then credit markets cannot function and if credit markets don’t function then trade and commerce is impossible.

It took us about 15-20 days to realize how closely interlinked with the world we were through the credit markets because our trade credit got affected, some of the companies were raising even their working capital requirements on the international markets. We started having the phenomena of these companies wanting to raise the same money in the Indian markets and we had a huge liquidity squeeze and two shocks in October when we went through a liquidity squeeze.

This resulted in an impact on the mutual fund industry because all corporates then wanted to withdraw from the liquid schemes of mutual funds.

The mutual funds in turn found that their underlying assets had no markets because nobody had money, so nobody was going to buy these assets. So we had to take some emergency action. The basic point I want to make here is that we are very closely interlinked with the world even though we are not a capital account convertible country and therefore the capital linkage is not so much but the linkage through trade is tremendous.

Since short-term capital got affected in this manner and credit market seized, the question for us to ask is why did something similar not happened in the equity markets? Why did people not lose faith in each other and why did they not stop transacting? The answer takes us back to the question that probably equity markets are organized far better.

These are exchange traded markets and these markets have what all called clearing entities. These clearing entities take the counterparty risks.

Therefore when a broker puts a trade on a stock exchange, he does not worry as to who the counterparty broker is. He knows that at the end of that day, the clearing corporation is my counterparty and that clearing corporation holds enough money by way of margins and a guarantee fund to be able to complete that transaction.

It is through building this infrastructure, these clearing corporations didn’t exist in our markets ten years ago, it is in the last ten years that this country has acidulously built these clearing corporations, the regulator has required and the market has responded by adequately creating big enough settlement guarantee funds and the ability to give this counterparty guarantee a margin mechanism which hasn’t failed despite the fact that more than 50% of the index is off.

The point I want to make with reference to this crisis is that this is an opportunity for us to study what went wrong not because we want to pin the blame on X, Y or Z or be happy that some developed markets made mistakes and we are great. But to study this phenomenon in order to learn as to what do we need to do when we become as big as them. Do we have the institutional capacity to handle these things and if we don’t what efforts do we need to make?

The bank said ‘I do not know how to value the assets in my book’. So when there are over-the-counter trades as opposed to exchange trades, prices are not transparent and when prices are not transparent, it is not possible to create a clearing agency which will clear this trades with the guarantee that irrespective of who your counterparty is I will put this trade through.

So to my mind our effort as regulators, as systems, as market player should be to see that we take as many financial products as possible on to an exchange traded market.

One of the small beginnings that we have made in this direction is to bring currency futures on to the exchange traded platform.

Edited by furkanalam - 23/Nov/2008 at 12:33pm

Udayan Mukherjee: I meet a lot of investors as well and last year from house wives to students everyone was playing the stock futures game, everybody bought it and lost a considerable amount of their savings in the last few months. Now a lot of people are asking whether it was the right thing to allow such inexperienced people or give them the avenue of a very inexpensive way to participate in the market and to take on leverages because futures is a leverage at the end of the day or should it have been the regulators choice to get these kind of inexperienced investors only through more institutional kind of frame work, what’s your assessment on that?

Bhave: Let us first look at the ability of any regulator to say that ‘X ‘ investor is qualified to participate in a market and ‘Y’ investor is not. There is no such ability to either permit the markets to happen or not to happen. There are some very rough measures that can be taken, and you can say that I would not allow an investment below a certain ticket size, so trying to keep away inexperienced people from coming into the market, which is what was done with regard to the derivative markets. What we need is a lot of investor education as to what the risks of derivative markets are. A sales guy would only tell you only the bright side of the story saying if you invest Rs 10 today and the market goes up by 10% then you would get Rs 11 and in the last two years the market has gone up by 40%, so I am giving you a conservative calculation but what he doesn’t tell you is that the market can go down as well and you will loose your money as fast. So the point is the investor education needs to be intensified and it needs to be a continuous process. People many times refuse to learn from what is told to them, they learn only when they actually loose Rs 10 these are all different stages. The point we need to emphasize is investor education, but beyond the administrative ability of prescribing a ticket size it is not possible for us to say that one can come and one can’t and that’s not possible.


Udayan: The other refrain which happens is that after a market falls very sharply, allegations of manipulation are put to the forefront that the regulator didn’t look after me and the market fell because it was manipulated. Sebi put out a note two days back saying that there was no evidence pointing the case by ICICI Bank, which alleged there was manipulation. So is there anything that you found over the last nine months which suggests that there is any manipulative hand in the crash that we have had or anything that was untoward which is led, but those are the kind of allegations which float about. What is your assessment of the situation in that regard?

Bhave: One has to be careful typically when you are in grief because you are the one who has lost money so you would want reasons other than yourself as to why this money was lost, so people say the market is bad, some crook is operating there etc. As a regulator we take cognizance of these complaints, we look carefully through their transactions, we do an online monitoring on our own, so we don’t wait necessarily for a complaint to come up and see whether there are any certain patterns in trading. If we do find something then we come out openly. The moment we issue an order against any entity that is out in the public domain but till that order is published it is not far to tarnish entities with a black brush because you have still not gone through the due process and proved that that entity is bad. So whatever we have found, you will find our orders on the website. We haven’t found anything that is market wide that would gives us suspicion that something is gone wrong with the market itself.


Udayan: So we have the regulators assurance that unlike some of the last bull markets that ended in scams this time the possibility of a scam is negligible if non existent.

Bhave: The regulators answer, we haven’t seen such things so far.


Udayan: What’s Mr. Bhave’s answer?

Bhave: I was out of Civil Service for 12 years and out of any public post so I had a lot of liberty to have a personal opinion. But as public servants on public issues we aren’t allowed to have private opinions we have only public opinions.


Udayan: The fall of the last many months has to some extent been caused by withdrawal of global money in India and to that extent there is a suggestion that maybe the government looks at a market stabilization fund where it puts on a few billion dollars and soaks up some of the investors who are in a rush because of compulsions to exit the market. Do you think it’s a good idea for the government to even consider a market stabilization fund which soaks up some of this FII supply?

Bhave: We decided to do a broad based analysis of what is happening in our market based on published data, from September 1 to November 14. The stock exchanges put out data on how much the net buy or sell by FII’s and by domestic institutions was every day except for mutual funds. They give out mutual fund data separately. They give data on the proprietary accounts of brokers and data about non institutional Indians. So I was curious about what happened between September 1 and November 14.

The analysis is as follows; on the net sales side, FII’s sold Rs 22,000 crore worth of stock in this period of time, the proprietary positions of brokers sold about Rs 700 crore worth of stock. Mutual funds bought about Rs 1000 crore. The domestic institutions have bought about Rs 16,000 crore and domestic non institutional investors have bought stocks worth Rs 5,600 crore between September 1 and November 15 on a net basis so this is buy minus sales. If you think that Indian investors don’t have money or if they are running away from the market, think again. There are smart guys sitting out there who say that this market is giving me valuations where I need to invest. These are net figures. Are FII’s only selling or they are buying as well? Normally the ratio of the buy by the FII’s though to net sale is something like 3:1. So they buy three and sell four and the net is one sale. So I had a lot of conversations with various FII’s as to what is going on are they buying or selling leaving or getting in the country, valuations are good and so on. This is anecdotal and not statistical. The evidence seems to be that the leveraged FII’s are going out of the market, so hedge funds and so on that were leveraged are going out.

Institutional investors like mutual funds or others investors whose clients are leveraged are also leaving the markets because the clients are asking for redemption. But long term funds like pension funds, university endowments, individual huge trusts that are managed are investing into the market. Investors said that they stayed away from Indian markets through 2007 because it was wrongly priced but they are investing in Indian markets again now. So what is happening in the market is lot of leverages are going out and equities going into the hands of people who have patience. Who know they will not make money in the next six months and don’t even know whether this is the lowest point of the market or not but believes that this market is good enough to buy.

So when we say there is panic among investors everyone is selling and is at a loss, we should look at the data a little more carefully. The data is a more nuance picture it is not as simple as everyone getting out of the market.


Udayan: Why is that there is been so much regulatory focus about either letting FII’s in or getting them out. Last on account of the rupee strength the Sebi said that they would not allow any participatory note money in. More recently there was going to be asking FII’s to revert their short sale positions, so if indeed people are buying and selling and there is no panic or no skewed kind of market action. Why did the regulator first stop participatory notes and then allow it and then also consider things like reversing short sales?

Bhave: All of us must understand our FII policy. There are little odds with our capital convertibility policy. On the FII front we are capital convertible because we allow capital to freely come in and go out. When you have this kind of a thing some distortions are bound to occur. It will not follow a logical path and therefore last year India was facing a peculiar problem that we had a trade deficit and the rupee was appreciating and the government had worries about what happens to exporters. So it was thought that this PE note route which is bringing a lot of money needs to be checked. Our experience shows that the PE note didn’t affect us at all. Money kept coming in and it stopped coming in only when the market started going down. So when we reviewed it we thought it is not an effective policy with regards to the off shore lending and borrowing of stocks. Our point was simple FII’s are not allowed to borrow or lend in the domestic market OTC they are allowed to do it only as an exchange traded activity s we didn’t want an arbitrage between what they do in overseas and what they do in the Indian market.

Very impressive interview indeed !!