Managing Financial Innovation in Emerging Markets-Remarks by John Lipsky, First DMD, IMF

February 12, 2010:

My IMF colleagues and I have watched with great interest – and satisfaction – the strides that India has made in its economic policy management in recent years, and that has been reflected in the economy’s impressive progress. In particular, I would like to underscore the RBI’s adept handling of monetary and regulatory policy in the current financial crisis. This is a testimony to the professional qualities of the RBI’s skilled senior staff and to the leadership of Governor Subbarao and former Governor Reddy. As is recognized widely, India is well positioned to continue on its path of strong and inclusive growth, thanks in no small part to the RBI’s stewardship.

Despite the unsettling and even dramatic recent global experience with “cutting edge” finance, I believe that without a renewed effort to foster financial innovation in the global economy, all countries—including emerging market economies—will underperform their potential. The principal challenge for policymakers, then, is to strike an appropriate balance between financial openness that supports growth-enhancing innovation while at the same time implementing regulations and effective supervision that limit the potential risk of financial instability.

Great strides already have been made in the development of the Indian financial system. As the recent Rajan report noted, “India’s financial sector is at a turning point. There are many successes—the rapidity and reliability of settlement at the NSE or the mobile phone banking being implemented around the country indicate that much of the system is at the Internet age and beyond. There is justifiable reason to take pride in this. Yet much needs to be done.”

Growth and the Financial Sector

There is a clear connection between economic growth and the state of development of the financial sector. Speaking late last year at the Bank of Mexico2, I reviewed the economic literature on the relationship between finance and economic growth. At that time, I highlighted that for many decades the financial sector largely was ignored in theories of economic growth. In fact, only since the 1990s has the important role of the financial sector been widely accepted.3

In modern market-based economies, financial intermediation is a critical determinant of performance. As economies develop and mature, so do financial markets. The accompanying infrastructure also has evolved to meet the wide range of needs of households, businesses, and government.

Looking forward from the current conjuncture, financial innovation has at least three principal tasks. First, it should address the challenge of missing markets, such as those for the long-term financing that is required for creating long-lived assets, or for efficient risk sharing by providing appropriate insurance and hedging products.

Second, it should deepen liquidity in existing markets, for example by reducing excessive reliance on a narrow base of depositors for funding. And, third, by raising the quantity and quality of investment, it can increase efficiency in the economy as a whole.



The limits of traditional banking systems

A key challenge faced by many emerging markets is their heavy reliance on traditional commercial banking. While such a system may be more than adequate during the early stages of a country’s development, it may act as an unintended constraint on growth as the real economy becomes more complex and as the demand for financial services expands. There are several reasons for this:

First, in the absence of robust debt and money markets, the ability of banks to grow their loan portfolio is limited by their access to deposits.

Second, banks are not well placed to meet the significant needs in emerging and developing countries for long-term infrastructure financing. The size, maturity, and illiquidity of such loans make them unsuitable for traditional commercial bank financing. The danger in such operations is that banks would take on inappropriate levels of credit and interest rate risk or else operate under a system where the government provides a financial backstop, and hence, passes on the risk to taxpayers.

And, third, commercial banks often are not well-placed to diversify the credit risk in their loan portfolios—their financial performance therefore typically mirrors the underlying condition of their borrowers and of the local economy.

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(Extract from Speech of John Lipsky, First Deputy Managing Director, International Monetary Fund At the RBI International Research Conference... Read more )

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