The regulatory blinkers

Print edition : April 14, 2001

The current turmoil in the bourses could have been avoided had the regulatory bodies not ignored the early warning signals.

FOR the ongoing turmoil in the stock exchanges, the regulatory authorities deserve a sharp rap, both for their unwillingness to learn from the past, even more important, for not paying heed to the early warning signals. Evidence that things were not what they seemed to be was available as early as January 2000. However, nothing was done and now, after 15 months, the situation has developed into a crisis of confidence for investors.

SEBI chairman D.R. Mehta.-

The blame has to rest with the Securities and Exchange Board of India (SEBI) and, to a lesser extent, the Reserve Bank of India (RBI), for not ensuring better disclosures of bank lending against shares, especially to stock brokers.

What shows up as a gaping hole in the administration of capital market regulation is the fact that the Ketan Parekh-centered operations and problems seem pretty much analogous to the ones witnessed in 1992 during the Harshad Mehta crisis.

In the intervening nine years, SEBI had put in place numerous regulations touching almost every aspect of capital market operations. The markets have also changed in terms of trading systems, enhanced institutional investor presence and a depository system that has removed the scope for much mischief. However, still if there have been flash-points every two years, then a lot of it has to do with the following factors:

* The quality of implementation of regulations by SEBI has left a lot to be desired. Even if one ignores the ongoing secondary market turmoil, in other areas too SEBI has adopted a benign approach. In the last five years, virtually every major corporate action, be it merger or divestiture, was preceded by significant price changes pointing to informed/insider trading (trading on the basis of privileged and unpublished information). All that SEBI has to show for is one solitary case against Hindustan Lever. However, even this case hinges on rather technical grounds. A benign regulator has emboldened market players to trade on the basis of inside information, which is the most serious aspect of the capital market as far as investors are concerned.

* The regulatory mindset has also been geared to adopting a posture of benign neglect or indifference when stock prices go up. But no sooner do they show signs of distress, the system goes into a hyperactive mode. The regulatorial overdrive is all the more evident when there is some pressure from the government. Little do they seem to realise that it is invariably a speculative bubble that leads to a price crash. So it is really a case of SEBI not looking at the root cause in time. In the latest case, the extraordinary bull run in information technology, telecom and media stocks of companies with a dubious reputation was ignored right through 1999 and 2000. In contrast, SEBI is making too much noise when prices have hit rock bottom.

* Passing up warning signals and reacting belatedly have almost become a favourite pastime for SEBI. In the present turmoil, the published figures of leveraged trading - 'badla' on the Bombay Stock Exchange (BSE) and Automatic Lending & Borrowing Mechanism (ALBM) which has taken off on the National Stock Exchange (NSE) in the last six months - had pointed to pressures building up in the case of select stocks. The outstanding positions (that is, the sum total of transactions whose settlement is postponed to a future date) in the set of core 'Ketan Parekh stocks' such as Zee Telefilms, DSQ Software, PentaMedia Graphics, SSI, Satyam Computers, Himachal Futuristic, Global Tele-Systems, Silverline Industries, Aftek Infosys and Padmini Polymers just kept on rising despite a fall in the prices of these shares. Prices of these stocks had declined by 70 to 90 per cent. In such a situation, huge 'long' positions (purchases) being carried forward should have attracted a close look from the regulators and led to the issue of warnings to investors about possible price manipulation that could be costly.

* There was also the spurt in trading levels in the stock exchanges in general, with most of these stocks moving to the list of top ten traded stocks almost every day. Given the low delivery levels, circular trading could have been the only reason. But SEBI chose to satisfy itself with technicalities such as compliance with margin requirements and exposure. For the NSE and the BSE to be satisfied at this level may have been understandable, but not for the apex regulator. If it had dug deeper and learnt lessons from the past, things may not have come to such a pass. There may also have been some clues to have about the source of liquidity.

* Technically, much of what Ketan Parekh has done is within the bounds of the law. But price ramping, insider trading, highly leveraged positions spread across a series of associate brokers, collusive behaviour between promoters and market operators and circular trading (where big trades are put through among a few players) have been rampant. Things unethical must be brought into the 'illegal' category where pecuniary interest and public services are involved. Unfortunately under the present system, such practices carry penalties that are not of a deterrent nature and are small in relation to the potential for private gains. Proving such cases is also difficult. But a look at the operations of the Securities and Exchange Commission (SEC) in the U.S. shows that a strong regulator can put fear into the market players by making the price for excesses a genuinely stringent one.

* There is only a negligible level of transparency in the operations of SEBI. The most prominent example is the fact that the investigation report in the BPL, Videocon and Sterlite stocks transactions in 1998 (which led to a big crisis on the BSE) has not yet been made public. Legal constraints may have now come in the way, but in the first place there was nothing to prevent SEBI from publishing its investigation report.

Moreover, very little is known of the deliberations of key committee meetings such as the one of market surveillance and mutual funds. This lack of transparency has reached a point where even decisions on some takeovers have been made known to a couple of mediapersons without being put on record in writing or on SEBI's website (www.sebi.gov.in).

* The procedure for regulation making is ad hoc and so many changes are made from time to time with little rationale. The regulatory framework governing takeover, private placement, preferential offers and threshold for public offering of equity have been announced without due process. In contrast, the SEC has discussion papers, articulation of views by its top officials (who, incidentally, unlike the SEBI top brass do not comment on market price levels), empirical back-up for proposed changes, draft papers, a public comment period, the final regulations and then an ongoing study of the impact of the regulatory change. In the case of SEBI, one would find no signs of such process and it leaves ample room for regulation at the behest of vested corporate interests and the government. For instance, the hike in the threshold limit of acquisitions for 'open offer' under the takeover code from 10 per cent to 15 per cent of the equity of an acquired company was done just before a couple of big business groups put through major acquisitions.

* SEBI turned a blind eye to the rampant speculation on the Calcutta Stock Exchange (CSE). This, in turn, was also responsible for the current crisis. Despite vast improvement in trading systems in terms of regulation and technology, the CSE had an unofficial badla system that was allowed to continue at great risk to the market. Although the CSE has had heavy trading volumes (way behind the NSE and the BSE), the delivery percentage was extremely low. This coupled with the unofficial badla and the official badla meant a market that was virtually outside the system. That difficult to-be-deferred open positions were shifted there is well known. But SEBI allowed the exchange to start a modified carry forward system when it had a good chance to clean the stables.

By allowing the practice of external bail-outs - where some companies and institutions throw a life line to market players in trouble - brokers were encouraged to believe that if there is a difficulty somebody would step in. In the recent crisis, Unit Trust of India (UTI) and a prominent business group known for its widespread tentacles and lobbying purchased shares of DSQ and Himachal Futuristic at discounted prices. Such bail-outs always have a quid pro quo and are not good for the market as a system. This has happened on the BSE and the CSE at various points of time. In contrast, the NSE handled such cases through its National Securities Clearing Corporation and then proceeded against the brokers. This is a cleaner approach which remains within the market system.

* One key area where there was a failure was with regard to disclosures, especially of leveraged positions. More so, since the RBI and the government have been encouraging banks to be more active in equity related activities. It is another matter that banks continue to exhibit a high degree of caution. A few banks, especially the private sectors ones, have been aggressive but have handled their exposures well without taking a knock or being taken for a ride by brokers. It is once again the public sector banks and cooperative banks that have taken a knock with Bank of India and Dena Bank identified as victims so far. Despite the caution exercised by the banks, the level of their advances from a stock market perspective was fairly high. Even when it constitutes less than 2 per cent of all advances, the amount of about Rs.10,000 crores was three times the volumes that pass through the ALBM and BLESS (as 'badla' is called in the BSE). Since the amounts involved are high, a disclosure of the top 20 stocks against which lending has been done by the banks would have helped all investors assess the effect of leveraged positions. Unfortunately, now it is privy to a few. Mandating this should be easy to do and implement since the beneficial ownership in favour of banks is recorded in National Securities Depository Ltd (NSDL). Seen in conjunction with ALBM and BLESS positions, the disclosures may have ensured better market response to building pressure points due to excessive leverage.

However, the 2001 crisis is not a complete disaster story. The crisis was not so severe that stock exchanges had to be closed down, something that was witnessed in the past. The fact that exchanges were open meant that investors could trade albeit at lower volumes overall. This is a good sign as any closure of a market usually disrupts the system. The fact that the professionally managed NSE has managed to come through the turmoil in a smooth manner is a source of encouragement. It has also been proved that a clearing corporation type of arrangement and the absence of hands-on role for brokers in the running of a stock exchange as prevalent at the NSE, are superior.

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