3:16 pm - Friday January 21, 4907

It is wrong to attribute financial crises to innovation

Blaming the financial innovation for the recent financial crises was the least thing I expected from a person none other than Lord Turner, Chairman of the Financial Services Authority of the UK. (Financial Times 16th Feb 2010)

In his speech delivered at Reserve Bank of India on the occasion of C.D. Deshmukh Lecture on Feb 15 2010 at Mumbai, he was rather skeptical about financial activity, financial innovation and thereby about the entire financial industry. He also doubted the efficacy of financial innovation being beneficial to the society.

According to Michael Porter Innovation is the central issue in economic prosperity. Innovators always look for improving the lives of the people. Financial innovators are no exception to this rule. They try to maximize the benefits for the players in the financial industry. They only provide the art of possible.

They should not be mistaken that they do also provide the art of profitable. In my view, that is the job of the regulators – to find out whether such innovations result in profits for the society as a whole. If the regulators do not do their job properly, it is not their job to blame the innovators either.

Let us take the subprime crisis case in point.

It was principally wrong on the part of the banks to have lent such huge sums to sub-prime borrowers. The regulators could have exercised control over the portfolio and the policies that go into it. They could have cautioned and guided the banks with a carrot-stick approach.

There was nothing wrong on the part of these banks, to subsequently bundle these assets for sale to potential investors. Of course it was wrong for the credit rating agencies to accord best rating to this bundle. The regulators did not have any control mechanism over these rating exercises.

It was wrong on the part of the investors – both individual and institutions – to subscribe to these dud investments even though they were packaged well. These investors did not receive any regulatory guidance as well.

This being so, blaming the banks for being innovative in the first place to lend sums to subprime borrowers, blaming the banks for innovatively bundling such assets, blaming the credit rating agencies for innovatively rating these bundles, and blaming the investors for innovatively investing in these bundled innovative instruments is the first thing a weak and ill-informed regulator will do to defend his/her position. And this is but natural.

To put it simply, if we had allowed such a tendency and framed rules banning financial innovations for they bring in financial crises, as commented by Lord Turner now, we could have continued to live in barter economy. Truly financial innovations facilitated our lives so far. There is no doubt about it. They will continue to facilitate our lives in future too.

The need of the hour as before is enabling financial innovations. The need of the hour is ‘a fresh breed’ of forward looking, facilitating, very intelligent, conservative and at the same time change conscious liberal regulators who know the implications of present actions/inactions and who excel in the art of foreseeing the warning signals and who can adequately prepare and guide the market place. The need of the hour is for regulators who have a stake in everything the financial industry is into including financial innovations.

And I bet, we will have such regulators in good numbers, in future.

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