By Tariq Choudhry
Many lessons can be learnt from the current global financial markets turmoil with the latest victim Lehman Brothers going down, heightening fear that some other investment bank or insurance company may be next in the line to go bankrupt in the near future.

Global financial markets particularly the US, had over the past many years a field day making billions of dollars as the economy boomed on the back of stock and property markets.

As these sectors blossomed, so did corporate executives remunerations and bonuses. But as they rightly say, good times never last. What the US market regulators were doing at this critical juncture and allowing these investment banks to over-leverage themselves without any questions asked, needs to be reviewed. Whilst the regulators sat back, banks over exposed themselves and allowed the bubble to grow. Some hard questions should be put up to the regulators and some serious answers sought.

And what can Pakistan learn from the catastrophe that has taken place in the global market?

The State Bank of Pakistan adopted strict regulatory measures which ensures that our banks are well guarded against any downside in the economy. But there is no room for complacency. Yes, it can be argued that our banks and other financial groups are not exposed to the sub-prime market and other market instruments which were the major reason for the downfall in the US markets.

Moreover, our banks were not over exposed to the housing sector which is the prime reason for the fall of Lehman Brothers, as housing prices fell, putting pressure on their market exposure. Our banks have very little exposure in the housing sector, with only consumer financing being a concern, but apparently, all banks are adequately provided for.

But a lot of hard work has to be put in for the stock market regulator, the Security Exchange Commission of Pakistan (SECP) which does not have sufficient expertise- to pre-empt any major financial wrangling. The stock market in particular, which has eroded more than 40 per cent of its value this year should be the major focus of the SECP. It is the state of stock brokers who remain over-leveraged in equities which has been the major cause of the decline and current state of affairs at our capital market.

It is also being whispered that brokers who have their own proprietary books, are mostly leveraged. As stock markets fall, broker’s positions comes under strain and they are called to top up their leveraged positions, particularly by banks who strictly manage their exposure to stock brokers or borrowers by providing funds pledged against shares.

The ‘floor’ mechanism was done to avert default of some brokers which may have caused the stock market clearing house to default. The negative fallout of this measure has resulted in a total lack of market liquidity, no exit point for both local and foreign investor and more important of all — increased anxiety.

What will happen once the market reverts back to normal trading? So, whether it was the right decision to put a ‘floor’ on the market and will it achieve the desired results, only time will tell.

The positive contribution the broking community has made to the economy cannot be ignored. Some of the big brokers have contributed to privatisation and most important of all, set up local industries such as cement, steel, fertiliser, banks, asset management company’s etc. Being stakeholders, they must be taken into confidence if the government wants to revive the economy and restore the confidence in the capital market.

This leads me to discuss the most important lesson our regulators can learn from the current global mess. Curb leveraging. The SECP and the KSE board must first of all review the Continuous Funding System (CFS) more popularly known as Badla. This mode of financing is available freely to equity investors through the Karachi Automated Trading System (KATS), but is also seen as the main culprit whenever markets tumble.

Leveraged-based investors tend to over expose themselves, and whenever there is a down turn in the markets, the very same leveraged investors put their hands up as they do not have the resources to meet their settlement obligations. This results in brokers taking the hit, as the client does not have the capacity to make payments.

One cannot solely blame the Badla system, as it is imperative that brokers have a strict margin and monitoring system. However, as brokers tend to overlook the margin aspect due to client relationship, it actually ends up bringing their downfall. Stakeholders must now realise that the Badla system is outdated and be replaced by new products such as margin financing. There is a lot of resentment against this product, but we must understand, such strict measures are actually in our favour.

Banks will be strict in managing margins which would result in a more sound and stable stock market. Yes, there would be times when markets fall as it is normal for markets to go up or down, but the end result would be lesser defaults, and lesser brokers taking the hit. More important of all, the clearing system will be more secure and would actually bring more confidence to our capital markets.

Initially we may see a reduction in volumes, but in the longer run, it will induce increased volumes. India used to practice the Badla system, and has abolished it many years ago and introduced margin financing products. It is reaping the benefits.

The way forward is in change, and in my view, it is time we moved on, and stop looking for excuses, to save our capital markets. In ‘change, there is opportunity.

The writer works for a private securities firm.

http://www.dawn.com/2008/09/22/ebr13.htm