Monday, October 16, 2006

Banks -- Their importance to financial markets

With the Sensex at an all-time high of 12900, I do not know what to think about investing in the stock market. Idly, my hands went to a book which I had written in September, 1991 (it was published in November '91 by Bharat Law House, Delhi). One small extract from it struck me as relevant even today as a sobering thought and influence.

"Our stock markets are still not so large that they cannot be affected except marginally by the actions of a few large operators acting in concert. This has happened today ... Already the BSE Sensex (Sensitive Index) has risen over 65% over only one year -- from around 1200 to nearly 2000 today. This is the tell-tale evidence of too much money chasing too few shares."

And another one:
"... there is a logical limit beyond which share prices cannot be leveraged. This limit is linked to the amount of real assets which all shares represent in totality. As long as there is some relation of the amount of shares available in the markets and the amount of real assets represented by this share capital, share prices can be maintained.
But what happens when, for every rupee of real asset, there are Rs.10,000 or more worth of shares? There will be many companies and funds which have no real assets barring a table and a chair, and yet, they will be capitalised in the millions on the stock market.
When too many such companies come to exist, sober reality will begin to assert itself and the stage will be reached when the people will realise that the Emperor is not really wearing clothes at all. Then will come the massive denouement: prices will begin to plummet in the stock market and people will lose confidence in all shares. This is exactly what happened in the United States" (in the late 1920s)
... What we are seeing is the beginning of an investors' bubble: the task before the Establishment is to puncture the bubble before it gets too big, and puncture it without it bursting, but so that it subsides gradually. By all standards, this is a delicate task."

This proved very prophetic --- and very soon too. In May 1992, a scarce 5 months after this was published, came the first denouement. Then we had the Ketan Parekh lesson of the mid-1990s. Each of these saw two banks go belly-up. In the first, it was the Bank of Karad and Metropolitan Co-operative Bank. In the next, it was Global Trust Bank and the Madhavpura Co-operative Bank. The lesson I saw in these experiences was that banks are the soft underbelly of the financial marketplace. If you have strong banks with robust processes and people, that is the best insurance against major shocks in the marketplace.

No comments:

Post a Comment