Thursday, August 5, 2010

Global Financial Safety Net

Gov. Kim Choong-soo, South Korea's central banker has called for strengthening of the global financial safety net.

Let us be clear where many of these problems and bailouts originate. Markets, by nature, go up and down. Thus, they throw open possibilities of profits as well as losses.

So long as exposures are "reasonably intelligent" (i.e. not taking exposure to absolute duds), valuation losses can get translated into valuation profits, so long as the person has the holding power. This is the principle on which most bail-outs are based - Long Term Capital Management in the US in the 1990s, Unit Trust of India a few years later, and the most recent bailouts in the US and Europe. Over time, valuation gains in the market address the problem; financiers can be repaid. As a luminary mentioned last year, it is privatisation of profits and nationalisation of losses!

Let us look at the trend.

1. First, there were individuals who chose to speculate beyond their limits (or live beyond their means). Banks who funded them had to take losses. The individuals were effectively bailed out. (There was no other option. Unlike organisations, individuals cannot be liquidated through legal means!)

2. Then, banks (and others) chose to speculate beyond their limits. Governments stepped in to bail them out.

3. Then Governments went beyond their limits - other governments stepped in to bail them out.

As we go higher and higher in the hierarchy of defaulting entities, the problem gets more and more challenging. An individual defaulting can only bruise the lender's balance sheet. A country defaulting can spark a global recession - or worse, depression.

Now, a global finacial safety net, is a message to banks and countries - we are there to bail you out in case of trouble. Will this not promote more greed to benefit from the markets by speculating beyond limits?

Enjoy your profits. If you can't bear the losses, some one in this globalised world will step in to bail you out. Greater the losses, more the chances of being bailed out. You will be TBTF i.e. Too Big To Fail.

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