Financial Innovation in India-Boon or Bane..

Four decades-worth of extraordinary financial innovation were, until recently, regarded as cause for congratulation among Indian policymakers and bankers. The events of the past four years have put an end to that. As well as stirring up controversy over the bloated size of the financial sector, financial analyst argued that much financial innovation was socially useless. Is it time, then, for regulators to incorporate a bias against such activity? Clearly, some innovation is beneficial. But there are not many innovations in finance that do not have malign as well as benign effects. One of the few I can pinpoint without clear drawbacks is the use of discounting to establish present values for different cash flows. This vastly improved the efficiency of capital allocation without adverse unintended consequences. Other great basic innovations have been double-edged. Interest, allowing the transfer of value through time, was miraculous. Yet it gave rise to the problem of usury. Paper money is a boon, but when unsupported by bullion is all too easily devalued. Insurance is essential to modern life, but involves moral hazard whereby a safety net encourages people to indulge in more risky behaviour. In capital markets, equity within a limited liability framework has facilitated capital formation on a scale that would have been unthinkable without it. Yet Adam Smith regarded it as an inducement to excessive risk-taking. Perhaps the nearest to a wholly benign conventional capital market instrument is index-linked debt. This curtails the ability of issuers to default through inflation. Yet the experience of index-linking is largely confined to the short span of history since 1945, so a verdict may be premature. The innovations that are most obviously useful have tended to come in retail finance. Those related to payments come closest to the ideal of being user-friendly without nasty side effects. Automated teller machines, though arguably more a technological than financial innovation, are a case in point. Yet plastic cards, which make day-to-day transactions so much easier, are often instrumental in creating the worst consumer debt problems. In wholesale finance, innovative products can have huge benefits and huge costs. Derivatives and securitization, which have been at the heart of the firestorm in finance, have also been hugely beneficial. They permitted the development of risk management to handle the volatility that became endemic after the breakdown of fixed exchange rates and the deregulation of interest rates. Yet the majority of innovations in wholesale finance are small scale and of no great import. The huge increase in trading volumes that has resulted from the innovative option pricing framework is admired by economists for the resulting increase in liquidity and market efficiency. Yet what is the optimal amount of liquidity in a market? Efficient market enthusiasts have no answer to that question. And the huge increase in the size of the financial sector suggests precisely that much innovation is simply rent-seeking that redistributes wealth to financiers at considerable cost to society.

Perhaps the best reason for regulators to be suspicious about innovation is that so much of it in the modern world is aimed at facilitating regulatory and tax arbitrage. That was certainly true of the banks' off-balance sheet securitization activity. But Lord Turner is right to argue that product regulation in wholesale finance is unrealistic. Because the social costs and benefits cannot be easily measured, it is better to use the capital adequacy regime to address the problem. A more fundamental point is that the real systemic damage in this, as in most previous financial crises, is done not by financial instruments but by leverage - one more reason to regard capital as the first and most important line of defense.