Post-Crises Financial Regulation: The Role of Research and Faculty Development 

Professor Krishnamurthy Subramanian talks to Anjan Thakor, John E Simon Professor of Finance and Director of the PhD programme, Olin Business School, Washington University in St Louis, on the current financial climate including banking regulations and the corporate bond market.

Krishnamurthy Subramanian: What are your thoughts about the level of conservatism and aggression on the part of banking regulators?

Anjan Thakor: When you don’t have private banks competing with each other, innovation incentives and incentives to take risks get muted. In a very perverse sense, you may end up sacrificing economic growth rather than facilitating it. It is true that a competitive system can become overly aggressive. But that is where market discipline works. In the short run, excess competition leads to more risk and fragility but in the long run, it actually promotes stability. An analogy is the human immune system. If a child, who is not vaccinated against chicken pox gets the disease, it is fairly harmless and a lifelong immunity is developed. However, the people who do not get chicken pox when they are young, as adults, they often end up getting shingles, which is a more deadly disease. The same applies to the financial system. If you don’t allow a small number of failures or expose the system to short-term fragility, in the long run you have big crises.

Krishnamurthy Subramanian: The temptation to resist bailouts has been difficult even in the United States, which is sort of the benchmark for market discipline. How credible is it that such discipline will work in an emerging market context where political forces might be much stronger compared to market forces?

Anjan Thakor: I think there is no silver bullet here. In a state in which it seems expedient to bail out banks, it is very hard for politicians to be able to resist doing that. But the consequences are adverse. To me, the only protection against it is a strong regulatory body, staffed by economists, not lawyers or politicians. With independence from politicians, you must let these regulators do the right thing. The other measure is to not allow institutions to become too big and important. This comes at a cost. By allowing banks to get bigger, they are economies of scope. But I think that the lesson we have learnt is that you cannot let banks get too big or too important. So it is both. By too big, it is not only in terms of the size of the balance sheet but also the inter-connectedness of the bank. There is a new definition in the US of systemically important financial institutions (SIFIs). You want to be able to monitor your SIFIs and intervene in an orderly manner.

Krishnamurthy Subramanian: What are your thoughts on advocates who say that corporate bond markets will not develop unless there are stronger laws and institutions, because arms-length lending depends on the strengths of laws and institutions? Is there a way to leapfrog this process and activate a corporate bond market?

Anjan Thakor: Well, many of the institutions are important for the functioning of markets, as you mentioned. I think informal institutions and self-regulation often substitute for formal institutions and government-based laws. So, if there is a strong perceived demand for the corporate bond market to develop, which is relatively small outside the US, this is because banking is much more important in the other countries. In the US, bank loans have substituted for corporate debt. But to the extent that one wants the corporate bond market to develop, if there is a perceived demand, then I think self-regulation should and can work effectively. Even if you think about the US context, it has really built the sequence because typically markets and institutions come up with their own laws. The exchanges on which bonds are traded come up with their own laws. If you do not have traded bonds, then you have implicit rules that govern bilateral transactions. But whether it is the private placement market or the public debt market, exchanges and other players can develop their own laws. I would call that self-regulation. If you observe the development of regulation, even in the US, you typically have self-regulation first. Often government regulation steps in when self-regulation fails or when you run into capacity constraints, such as with clearing houses in the US providing de facto guarantees. When that capacity was exceeded, it was realised that we needed formal deposit insurance by the government. So you could certainly think of self-regulation as one way in which you can get there before formal legal institutions are established by the government.

Krishnamurthy Subramanian: For India, financial inclusion is a burning issue. Since both priority sector lending and market-based solutions, such as microfinance, have their own problems, what do you think will give a strong push to this process?

Anjan Thakor: Inclusion must be encouraged using a different approach – one where you can facilitate and encourage the development of lending cooperatives. In the US there is something that most finance professors don’t know about – the Farm Credit System (FCS), initially sponsored by the US government. The whole idea was to ensure that the agricultural, fishing and gaming sectors, which were not served adequately by commercial banks, were able to get credit. Commercial banks had little interest in loans top these customers. So it existed as a cooperative and there are now almost 100 such lending institutions called “associations,” which are effectively banks. But they are all cooperatives and are backed by system banks that provide funding. System banks get funded by capital market issues, by the FCS using the Government Sponsored Enterprise (GSE) status. Then, they channel funds to the system. It works pretty well. I have worked with them a lot and I think this is a pretty good model. Now, I am not a big fan of the fact that they have GSE status but I don’t think that that is crucial. But even if you do give GSE status to reduce the cost of funding and provide some insurance to the market, that is alright. But I think in India, there are numerous opportunities in these sectors to develop local cooperatives. But local cooperatives have the disadvantage that they don’t have enough financial depth and can easily fail. You need to create a national system like the FCS, so you can create an analogous Indian credit system with many cooperatives. But the pricing of credit here is market-driven, because these are not government-owned institutions. So they have to survive in the market place. They are subject to the risks that normal banks are subject to. They have to do risk management. They have their own board which is basically their customers. The system can then flourish.

Krishnamurthy Subramanian: On the issue of corporate governance, we found that post Satyam fiasco, there were large scale exits by independent directors because of they perceived risk in the role. If we do believe that independent directors have a role to play as monitors and as advisors then this is possibly a negative outcome. There are costs that have been documented even in the context of Sarbanes-Oxley. For example, small firms have found the cost of complying with Sarbanes-Oxley exorbitantly higher. Given this, is there a regulatory solution?

Anjan Thakor: There are elements of Sarbanes-Oxley that are very good, but I think it went too far. There is some evidence that it has led to fewer IPOs in the US and firms converting to private ownership because they did not want to comply with its expensive reporting. I think that in the Indian context, I am a firm believer that more transparency is good and board independence is very important. We need more board independence in the US than we have at present. You don’t want to enact legislations, regulations or laws that impede their participation. That is why I am a big fan of the business judgment rule. In the US the courts are very unwilling to rule against a company just because it made a mistake. Basically the courts defer to the independent business judgment of the board and firm that you really have to show deliberate wrongdoing, criminal conduct to be able to pursue legal action successfully against the firm or its directors. I think it is a very wise rule. You have to balance the need for transparency against the cost of excessive disclosure. 

Krishnamurthy Subramanian: In the US and developed markets, there is this issue of de jure independence versus de facto independenceEven independent directors often tend to have social connections. So they may not be really independent. They are appointed by the CEO. These issues are even more exacerbated in the context of an emerging market, where a new relationship matters more than arms-length contracts. Should this be regulated? Or is regulatory failure worse than market failure?

Anjan Thakor: As much as I like independence of the board, there isn’t an easy solution to that problem. So for this notion that we should just make it easier for shareholders to appoint directors to board, there is a counter-point to that which, if you talk to CEOs, they will say, “If you give me a hostile board, I cannot function.” Putting people on the board who have an adversarial relationship with the CEO just doesn’t help. You can’t function if you have a board that is constantly playing the role of a policeman as opposed to a partner. And if you look at the governance of the firm, 99% of the time, the partnership is what is important. But I think that if you take the heavy hand of regulation and say that the government is going to appoint certain directors, I think you might end up creating this adversarial relationship between the CEO and the board. I don’t think I want to go that far. I understand the other side of the argument that it opens the door for the union to start putting people on the board and then you have problems. So again I think it is a delicate-balancing act.

Krishnamurthy Subramanian is an Assistant Professor of Finance at the Indian School of Business (ISB)

In the second of the two-part interview, Professor Krishnamurthy Subramanian talks to Anjan Thakor, John E Simon Professor of Finance and Director of the PhD programme, Olin Business School, Washington University in St Louis, on the importance of research and on building a strong team of faculty at the Indian School of Business (ISB).

Krishnamurthy Subramanian: As a ten-year-old institution, ISB is still finding its feet as a research-oriented institution. The School’s vision is to be known as a thought leader for tomorrow. However, we must recognise that publishing in the top-tier journals is a culture that is often not very natural to countries outside the United States. As such, in this debate between relevance and rigor, what are the steps that ISB must take and who are the stakeholders that ISB needs to engage in the path towards realising this vision?
Anjan Thakor: I think that for business schools, there are two key stakeholder groups – recruiters and faculty. Under recruiters, one group consists of the companies that are recruiting your students and the other comprises companies that you would like to welcome on board as recruiters. You need to engage with these companies and ensure that you understand their needs. You must also make sure that the students they recruit fit those needs. The other key stakeholder group is faculty. Besides that, there are also other important stakeholder groups such as students, alumni, etc – but they all fall in place if you attend to the two key stakeholder groups that I mentioned. You must make sure that your faculty has the resources to do high-quality research and an environment that is conducive for that. I think having high-quality faculty who engage in high-quality academic research is the lifeblood of a good institution. I really believe that. Often, people question the need to have faculty who publish in top-tier journals that business people can’t read. I think this is important for a lot of reasons. Firstly, people misunderstand the role of research in teaching and in the success of an institution. If you have a high-quality academic research focus, it attracts the smartest people and brings cutting-edge research into the classroom. There is a difference between a faculty who is simply presenting material researched by somebody else versus someone who is teaching from his own research and imparting the practical applications to students. There is a qualitative difference; but as teachers, we have to do both. We can’t just teach based on our own research. We also have to teach material that other people have developed but we know that there is a difference in the level of enthusiasm, conviction and passion that is brought to the classroom when you are talking about your own research. Having cutting-edge researchers implies that more cutting-edge knowledge is being brought to the classroom. This also permits creation of knowledge that helps companies think about the “next practice”s as opposed to “best practices”. This is a term coined by CK Prahalad, my former colleague at Michigan. He used to talk about this with companies. According to him, you have to lead the thought process in companies as opposed to simply telling them about the best practices. Research enables you to do that. I think applied research is important too. You have to be able to bridge the gap between what we publish in journals and what somebody else is going to read. For this, you need to have a good core of clinical faculty who are doing applied work or writing books that managers read. The best example of that is probably Harvard Business School. But there are others as well. When I was in Michigan, we had a core of thirty or so clinical faculty. They had a ladder rank system and they were required to publish and have visibility within the corporate communities. To get promoted, you had to have CEOs write letters of recommendations for you if you were a clinical faculty member. These professors were not tenure-track. But they had their own system of evaluation and they were encouraged to think independently and create knowledge that was more applied in nature. The other thing I would say to educational institutions like ISB, and Indian companies in general is to have more of a global ambition. I see that in China. The Chinese have enormous global ambitions. They think about the time when they were the dominant country in the world and they want to return to those days. When I come to India, I sense that there is so much satisfaction with the economic growth that has occurred, that people seem to have forgotten the glorious tradition of this country. Between 500 BC and 1400 AD, India was the richest country in the world. There was a time when this country had close to 40% of the world’s GDP. These are also the times when the Greeks, Romans and Egyptians were thriving, so these numbers for India are truly impressive. We have got to think big. We can’t be satisfied just because we are growing at 8% a year. We cannot be satisfied with five or six billion dollars in FDI. China receives 55 billion dollars in FDI every year. I think by the same token, ISB, for all its commendable success, has to think more globally. I would like to see this institution thrive as a global player on the research front and in terms of attracting students and faculty. Hong Kong University of Science and Technology (HK UST) had that ambition to be more global, so half their faculty now is non-Chinese and they are also very research-active. I would like to see ISB flourish as a global institution, as the School has a fantastic campus, great facilities, a good brand name, and an emerging research faculty. I think ISB also has the potential to become a more visibly-networked player in the global research community.