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

Implications for India

While India’s financial system is multi-faceted, with some world class segments such as its equity market, other segments—notably, the corporate bond market—remain less developed. Because of the limited size of India’s debt capital markets, banks are the main source of loans to both firms and households. Moreover, India has enormous infrastructure needs, but infrastructure financing remains largely dependent on bank financing, with all its attendant inadequacies and risks. There are also important issues of access to credit and financial services for Indian corporations, but especially for SMEs, and households.

A recent IMF staff study found that Indian firms increasingly have become reliant on borrowed funds (as opposed to retained earnings) to fund their investments, but the study also found that there are important inefficiencies in debt financing. In fact, firms in industries that are more dependent on such financing have tended to grow more slowly.4 A lack of financial instruments also has limited firms’ ability to manage risks. The limited availability of derivative products leaves corporations to shoulder risk-related costs that they otherwise would not bear and that may stymie their ability to expand. At another level, only 40 percent of India’s population benefits from a bank account, as a large number of households still remain outside the formal financial sector.

These issues are well understood here. Thus, several steps are being taken to meet the growing needs for more diverse sources of finance. Notably, the RBI has undertaken important initiatives to promote financial inclusion, with the goal of having a banking outlet in every village of more than two thousand residents by 2011.

Moreover, Indian authorities are targeting an increase in infrastructure spending of some $500 billion during the current five-year plan. With fiscal space limited, meeting this need in a prudent fashion will require a more developed capital market, and especially a more developed long-term corporate bond market. The India Infrastructure Finance Corporation Limited (IIFCL) has been established with a mandate to co-finance projects and issue local currency-denominated bonds. In addition, repos for corporate bonds have been introduced, as well as interest rate and currency futures.

Fortunately, there are several successful models of capital market development in emerging markets. The growth of corporate bond markets in Mexico and Malaysia, for instance, has been closely linked to the development of domestic institutional investors. Mobilizing such investors through the gradual liberalization of portfolio guidelines of insurance companies and pension funds would help transform India’s large pool of savings into investable funds for long-term financing.

However, liquidity may need to be generated in other ways, as these institutions typically are buy-and-hold investors. In India, increasing foreign participation in the local debt market would provide additional liquidity and more robust pricing of local bond market issues. A recent IMF study5 of ten emerging markets suggests that foreign participation has lowered borrowing costs. Of course, unfettered access by foreign investors to India’s large government securities market would create concerns, hence it would be reasonable to proceed in an orderly manner6.

Similarly, further progress in the development of an active securitization market for consumer and small business loans would facilitate greater access to credit, by enabling risks to be shared by banks and other investors. Such securitizations, executed prudently, would help to broaden the investor base and allow for the conversion of longer-term amortizing loans into instruments more suitable for institutional investors. This development would have the added benefit of facilitating better diversification by banks of their credit and maturity risks, while providing institutional investors with the opportunity to earn higher yields by taking on some of the risks of underlying loans. Of course, it is important that securitization include appropriate safeguards—I will say more about that later.

Facing Up to Risks

I recognize that there is a growing skepticism about the merits of moving towards a more modern financial system and away from bank-centric financial systems. It has been widely noted that major emerging markets have avoided the current problems being experienced in the United States and Europe. Some would argue that financial innovation ended up wreaking havoc on advanced economies—and indirectly on the rest of the world—and therefore should be avoided in emerging markets at all costs.

In my view, however, the financial crisis in the advanced economies was not primarily a function of asset securitization or the general growth of securitized capital markets. Rather, the crisis reflected a toxic mix of factors, including:

• Excessive complacency among both borrowers and investors regarding risk – including systemic risks – reflecting an extended period of exceptional economic performance and low market volatility;

• Poor governance and risk management at overly leveraged financial institutions, resulting in the development and spread of excessively complex instruments and of unexamined and unrecognized interconnectedness and fragility;

• The failure of some institutional investors to exercise the due diligence responsibilities inherent in their fiduciary duties;

• Regulatory arrangements that did not adjust effectively to financial market developments; and

• Supervision that failed to enforce standards effectively.

Happily, India is in a favorable situation in this regard. First, complexity of instruments is not currently a problem. Second, governance and risk management appear adequate in the current circumstances, and bank leverage is appropriate. Third, both the RBI and capital markets regulators have fostered a robust financial sector. This suggests that India has significant opportunities for productive and prudent financial innovation, leaving it in the enviable position of learning from the experience of others.

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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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