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The devil’s in the details: regulating financial innovation

Themes: Finance

Financial dataWith elections in India in a few months, the war on terror must be squarely at the centre of the political agenda. Not far away will be regulation of finance. As Sonia Gandhi put it, the poor had nothing to do with fancy sounding financial instruments. The livelihoods of the poor are at great risk now that financial globalisation has spread the damaging effects of some types of innovative finance across the world. Dr Paul Kattuman, Reader in Economics at Cambridge Judge Business School, looks at the unintended consequences of complex, unproven financial products and the lessons that need to be learnt from the crisis.

Until very recently financial innovation had appeared to be a growth engine, certainly in the US and the UK. Innovation drove the explosive (no pun intended) growth of derivatives till it came to exceed three times the size of global financial assets (broadly defined); itself four times the global GDP in 2005! Many were the keen and well trained minds that rushed to the city to bend to the lucrative task of designing and selling new and finely differentiated credit risk products. This century seemed well on course to be the Schumpeterian century, defined by innovation, led by finance.

Presciently, Schumpeter (1883-1950), who brilliantly analysed the way economies were propelled by the mechanism of innovation – and who coined the memorable phrase “creative destruction”, to capture the manner in which innovation created not only winners but also substantial losers – feared for capitalism in the long run. His concern however was that governments would be unable to provide the social insurance necessary for people threatened by the destructive counterpart of innovation. What we now see is an entirely different animal: notable innovators in a notably innovative industry are on the brink of ruin.

Mrs. Gandhi pointed out, as politicians do, the need to balance the freedom to pursue prosperity, with social justice; and of “liberalisation within the framework of sensible, but not heavy-handed, regulation”. This is of course, a hard problem. Innovations are hard to predict, and the regulatory understanding tends to lag behind. How are regulators to tread the narrow line between rules that are too loose, and those that are too tight? Are there any general principles that stand out that might be of use?

First, as in other industries, competition drove financial products to become more complex. As Schumpeter pointed out long ago, any new product tends to have a niche with high profit margins for a while. But the product becomes standard, market gets competitive, profit margins drop and providers begin to differentiate. Complexity makes direct comparisons of both price and product difficult, for buyers and for competing sellers, and is a source of profitability in all markets. Hence, for example, the bread and butter financial innovation of mortgages, led to the innovation of bundling mortgages into pools against which securities of different risk levels could be sold to buyers with different risk appetites. But when these securities were themselves pooled, and claims sold against such pools, and further, when securities of this provenance were again pooled and further securities issued against them, and so on… the instruments were so convoluted that they could not be priced even by their creators. Innovation engenders complexity.

Second, enlargement of market size by enabling entry of new classes of buyers, is an important type of innovation – for example, easier access to financial markets and to financial information to ordinary people, assisted by information technology. Innovation has a strong component that may be described democratisation in its pursuit of market size. In finance, this was not limited to more day-traders buying and selling vanilla financial products. Among finance professionals, marketing of complex instruments reached out to corporate mandarins who did not have the capability or the time to analyse these things. Innovative marketing and sales pitches, aided by ratings, democratised the market for complex financial products.

So what we have learnt is that when opaque financial products are bought by a wide range of people who do not understand them, at hit or miss prices, the consequence is the build up of tight and critical interdependencies in the financial system. Then small triggers can set off unintended but nevertheless fatal cascades of consequences. The lesson is that while it is simplicity that combines well with democratisation, the compelling logic of the innovative process is to harness both complexity and market reach.

Just like untested drugs, complex unproven financial products can have fatal side effects. A loose analogy that regulators of financial innovation might work towards is that of clinical trials. Designing and setting up a workable laboratory for this will take a lot of effort and capability, and international regulatory co-operation. But then many experienced, able and eager individuals are available for the purpose at this time. As Paul Romer said, a crisis is a terrible thing to waste!

This opinion piece by Dr Paul Kattuman was first printed in The Financial Express, India, 4 December 2008.