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

Modernizing Financial Systems

Ultimately, each country will develop its own approach to fostering appropriate and useful financial innovation. I would, however, like to offer a few general suggestions for emerging market countries looking to realize the benefits of financial innovation.

First, keep it simple.

Introduce products that are relatively straightforward and that offer clear value-added. Thus, new financial products should be understood by regulators, by sellers and by prospective buyers. Investors should be able to calculate the risks being undertaken without undue reliance on credit ratings agencies or other outside advisors. Close attention should be paid to ensuring adequate disclosure. In this regard, long-term institutional investors—including insurance companies, mutual funds and pension funds—are vital to securitization markets, because they can and should form a stable and sophisticated investor base.

Second, keep incentives aligned throughout the process.

In approving new products, ensure that the interests of the originators of loans and securitized assets are aligned with the interests of investors. As you know, the RBI has adopted a retention rule and a lock-in period for securitized instruments designed to align incentives—although it will be important to see what impact these will have on issuers. After all, the most seriously affected advanced-economy firms in the current crisis were grievously damaged by excessive retention of toxic assets – reflecting their sub-standard risk management and exacerbated by weak supervision.

Third, ensure that banks’ risk management systems and the regulatory system keep up with the pace of innovation.

The recently released Senior Supervisors Group report7 highlighted ongoing problems in the governance, firm management, internal control programs, and risk management in many of the world’s largest financial institutions. Notably, many boards of directors appeared to be largely uninformed about or did not understand the risks their institutions were undertaking. It is critical that governance be reformed, and that boards include members with the experience to take a useful role in monitoring and controlling the level of risk taken by their institution.

Regulation and supervision also must keep up with innovation. This requires both adequate resources to hire skilled professionals, together with political support to ensure that regulations and supervisory recommendations are taken seriously. Indian regulators have been a part of the global standard setting process and will continue to be early adopters of new standards. This should help to prepare India for ongoing and even accelerated modernization.

Fourth, develop a robust resolution scheme.

It is inevitable that in every financial market, some financial firms eventually will experience difficulties. A key policy conclusion highlighted by the crisis is that an effective resolution scheme must be created for systemically important firms, so that governments will be able act promptly and effectively when an institution becomes troubled. Such regimes should minimize potential market disruption as well as dampen moral hazard8.

Of particular importance in our globalized financial world is dealing with the cross-border dimensions of large institutional failures. Progress in this important task is taking place through development of contingency plans for global financial institutions by their home and host supervisors, combined with efforts to identify and address barriers to implementation of plans for the recovery or orderly resolution of these institutions. This is a complex undertaking, but it is extremely important.

In conclusion

Despite the current difficulties and challenges, financial innovation will continue to play an important role in promoting global growth, especially in emerging markets and developing countries. The current crisis can provide important lessons, and I am confident that our Indian hosts will draw useful conclusions. Hopefully, this inaugural International Research Conference will help to promote this process. After all, we all share responsibility for ensuring that the global financial system evolves in a manner that supports strong, sustainable and balanced growth.

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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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