One of the key lessons from the global financial markets crisis for India and other emerging market economies, according to the Governor of the Reserve Bank of India, is to strike a fine balance between financial regulation and innovation.

True to the saying that too much of anything is good for nothing, the Governor points out that "the present crisis underscores the need for regulation staying ahead of the curve, and for continually upgrading the skills and instruments for financial regulation and supervision. However, there is need for a note of caution here. There is a distinct risk that in trying to stay ahead of innovation, regulation may get so stringent that it stifles innovation. This is a risk we must guard against."

Implicit in this message of caution is an acknowledgement and indeed reiteration of the important role which financial innovation plays in promoting overall economic growth. In the backdrop of the extreme instability and systemic, global crisis which innovation in the US residential mortgage financing market has caused, such a reiteration of the useful role of financial innovation by the top financial regulator in the country is indeed welcome.

Innovations and instability are not novel

The Governor's view is obviously born out of the perspective that there may not be anything fundamentally new about the sub-prime mortgage related debacle in the US markets and the crisis it has spawned. The novelty, if we may call that, only relates to the scale of the crisis and in a financially integrated world, to the fact that a housing bust in the US results in a Japanese insurance company going under, a country (Iceland) collapsing and banks across the world facing a credibility crisis, financial strain and requiring government guarantees and bail-outs.

History is indeed full of examples of financial innovations that led, at least initially, to instability as market participants attempted to exploit innovations without due regard for the risks involved.

Commercial banking from goldsmiths

Modern day commercial banking, for example, was itself a significant financial innovation some three centuries ago in Europe, as it originated from the practice of goldsmiths issuing receipts against the gold deposited with them by customers. These ‘goldsmith receipts’ were an accepted means of payment. Goldsmiths soon found that as long as they maintained gold to satisfy occasional redemptions, they could issue receipts for more than the value of the gold deposited with them. Such receipts were effectively loans made to customers and being an accepted means of exchange, it promoted economic activity and trade and incidentally earned a good profit also for the goldsmiths. Fractional-reserve banking, as we know it now, is a system where banks hold only a certain percentage of their deposits as ready cash and it had its foundations in this ‘goldsmith banking.’

And it inevitably lent itself to bad judgments and misuse as bankers sometimes issued more loans (receipts) than the amount of gold (deposits) they held in their vaults. The result was financial stress as bankers found they did not have enough gold (cash) to make good on their promise to redeem their notes for gold on demand. Failures inevitably followed with all its adverse consequences for economic stability but in course of time, numerous mechanisms have evolved to provide more banking stability and prevent the deleterious consequences of banking panics. One such mechanism, for example, is the required reserve ratio (also known as the CRR in India).

Paper currency is another key financial innovation (closely related to fractional-reserve banking). The danger with a paper money system is that governments can simply take over the printing press to finance their deficits and this can result in hyper-inflation. But the benefits of a fiat money system are seen to be just too great and governments have never been able to abandon paper currency and revert to a gold-based or some other metal-based monetary standard. Therefore, here again, numerous mechanisms have evolved to keep governments away from the power to create money, key among them being the constitution of independent central banks which have the sole power to create (primary) money.

Fractional-reserve banking and paper money are tremendously important to the functioning of modern economies, despite the periodical crises they have generated. This is one of the key reasons why governments in the US and Europe are now using their national budgets to nationalise some of their biggest commercial banks (completely upturning their free-market economics ideology and probably hitting the last nail on the policy of laissez faire), all with a view to stabilising their banking systems and get the wheels of credit and finance moving again.

The sources of financial innovation...

Financial markets are always innovating. Some innovations are driven by broader technological advances. Some are purely a reaction to a profit or business opportunity. There are also innovations which are the result of regulation or other government policy actions.

A key payments / credit innovation of the last 50 years is credit / debit cards. The first credit cards were seen in the 1950s in the US but it was not until the late 1970s / 1980s that large credit card usage was established. The key reason was technology advancements which enabled the fast processing of credit card transactions. In India, there has been an exponential increase in credit / debit cards utilization in the last 10 years.

It is now difficult to imagine life without these electronic cards. They are a fast, convenient and safe method for making payments. In the case of credit cards, they are also a key channel for making short-term, unsecured loans which can enable households to smoothen their consumption over time. The risk and instability this innovation can cause, of course, is that some people borrow more than they can afford. But, overall, credit / debit cards are a key payment / credit innovation which has lowered transaction costs, improved resource allocation and supported economic growth.

Money market funds...

Money market mutual funds were an interesting innovation some 30 years back arising or rather necessitated by the ceilings which governments placed on bank deposit interest rates. These funds offered (savers) investors the benefits of both liquidity and a rate of interest higher than they could earn on bank deposits. Commercial banks, very early on, saw money market funds as a key competitor and over the course of many years have developed many deposit products (sweep accounts for example) which seek to provide depositors the same flexibility which money market funds provide. This therefore was an innovation which triggered greater efficiency in the intermediation of savings and investments in the financial system, though its initial impact was to modify the characteristics of the deposit base of the banking system.

Long-term amortizing mortgage - a landmark innovation

But, probably, one of the most important innovations which arose as a response to government policy action or rather built on the foundation provided by government action was the long-term amortizing residential mortgage. Prior to the creation of the long-term amortising mortgage (where the loan gets serviced and repaid over 20 years or in the US / Europe, over 30 years in the form of equal installments), home loans were short-term loans with a balloon principal repayment at the end of the loan tenor. This effectively (apart from the initial down payment or margin which even now is somewhat of a barrier to taking out a housing loan) made home-ownership unaffordable for large sections of the population. In the US, for example, home ownership registered significant increases during the sixty year period from around the late 1930s, rising from around 30 per cent to reach a level of around 60 per cent of all households by the turn of this decade. The key driver for this large expansion of home ownership was the concept of long-term amortisation which the Federal government put in place in the mid 1930s when it intervened in the housing market during an earlier bust.

The US housing bust of 1930s

The 1930s housing bust in the US was very severe and it is possible that even the current bust does not match that ultimately - a US government report shows that as of 1 January, 1934, nearly 50 per cent of all outstanding urban residential mortgages were delinquent. (Against that, various estimates put the current level of housing loans delinquency in the US between 7 and 10 per cent). The government responded to the credit freeze that followed by acquiring some 1 million residential mortgages and re-financed them as 15 year fixed-rate amortising loans. This was immediately followed by the creation of some specific housing agencies to develop the secondary mortgage market and the concept of long-term amortisation. In due course, the 15, 20 and 30 year long-term fixed rate amortising mortgage became the industry standard.

It is, therefore, no exaggeration to say that the mechanism of long-term amortisation has played a very critical role in enabling millions of households to acquire their own homes by borrowing. In India, housing loans have become a major asset category for commercial banks only in the last 10 years - more specifically in the last 5 to 6 years. Housing loans now account for around 12 per cent of total bank credit (and if the cross-country experience is any indication, it is likely to increase further strongly in the medium term) whereas even as late as 2002, they were less than 5 per cent of bank credit. And an important reason for their popularity is their greater affordability - caused not only by income growth and lower interest rates but also by the key innovation of amortization of long-term residential loans.

Innovation gone awry

Some innovations do go awry and can cause very serious damage as is happening in the case of the sub-prime mortgage. As we noted earlier, the initial deposit or margin payment for taking out a housing loan is still a formidable obstacle for many prospective housing loan borrowers - for example, people in the lower income brackets, those who have just entered employment or those who may not be able to document or prove a consistent source of income. Such people may neither have the resources nor a long enough credit history which can make them credit-worthy borrowers. The vigorous growth in house prices - noted not only in the US but also in many other countries including India - meant that home ownership was even more of a challenge for the class of borrowers below the ‘prime’ category.

The sub-prime mortgage and related innovations such as mortgages with adjustable rates, with an option for the borrower to pay up principal, to pay only interest, low ‘teaser’ interest rates in the initial period of the loan and other exotic structures were all designed to take mortgage finance to such a class of borrowers. To be sure, this was certainly risky territory and such a higher level of risk was duly reflected in the higher effective rates which were being charged to such borrowers.

But as has happened historically with respect to financial innovations and in a reiteration of the earlier saying, too much of anything is certainly not good for the system. Sub-prime mortgages, which accounted for less than 10 per cent of all outstanding mortgages in 2001 rapidly increased their share in the next 6 years. By mid 2007, 25 per cent of all outstanding mortgages in the US were of the sub-prime category. To put it in perspective, the total US residential mortgage outstanding is $ 11 trillion out of which 25 per cent was sub-prime by mid 2007. Home ownership in the US rose sharply from the 60 per cent level of 2000 / 2001 to touch around 68/69 per cent by 2007 on the back of this sharp growth in sub-prime mortgages. To have a perspective, just compare the growth in home ownership in the last 6 years with what was registered in the 60 year period from the late 1930s to the turn of this century as mentioned earlier in this piece. (This ratio, of course, would be under considerable strain now that foreclosures are at record levels).

Distortions and manipulations inevitably crept in to this period of rapid growth - borrowers took on more debt than they could handle, mortgage lenders and brokers put too many borrowers into unsuitable and exotic mortgages, too many adjustable rate loans were made without an adequate assessment of the borrower's ability to service his loan after the interest rate on the loan was reset.

Another key innovation of the early 1970s - securitisation of assets - also played its part in the creation of this global financial crisis. The aggregation of individual loans and their packaging and selling into the broader (and global) capital markets meant that a delinquency in the primary housing loan portfolio (created by the original lender) now manifested itself as non-performing and hard to value assets on the books of institutions / investors far and wide. That is why we see a Japanese life insurer collapsing as the value of the assets it holds falls below the liabilities / obligations it has contracted.

Lessons to be learnt...

One key lesson at the level of financial institutions is the need for greater capital and liquidity on their balance sheets. Greater capital and liquidity requirements will promote more prudent behavior as a financial intermediary (FI) seeks to grow its balance sheet through product innovations. This is likely to be a major thrust area in global financial regulation after the present crisis has subsided. The issue of greater maturity matching between assets and liabilities on a FI balance sheet is also likely to be emphasized heavily.

Financial markets participants can notice an interesting contrast between the S&L loan crisis in the US in the mid / late 1980s (which led to thousands of thrifts or small mortgage banks being wiped out and which required a bail out costing some $ 150 billion then) and the present housing market crisis. The S&L crisis was basically due to the extreme mismatches which S&Ls carried on their balance sheets - borrowing short up to 2/3 years and lending long for 30 years. The sharp rise in interest rates in the US in the early 1980s (Paul Volcker's fight against inflation) rendered the S&Ls insolvent. In the present crisis, the maturity mismatch, interest rate and default risks have been effectively passed on to the borrowers / investors through the mechanism of adjustable rate mortgages and securitisation.

Don’t fear finnancial innovation...

For the individual or the firm, the lesson is not to fear financial innovation itself but to be careful in taking personal financial decisions, so that not only do appropriate financial products get innovated but end-users also are enabled to make the most optimal or near optimal financial decisions. There seems to be a great role for public policy in fostering and improving awareness of financial matters and in promoting economic and financial education.

Economists, on balance, are in agreement that financial innovation has played an important role in supporting economic growth and like innovation in other industries, is part of the process of ‘creative destruction’ that makes the working of the economy more efficient. If history is any indication, sub-prime mortgages and mortgage securitisation, though they have become notorious concepts now, are likely to, become as accepted as fractional reserve banking, the fiat money system, credit cards, money market / equity index mutual funds and other financial products and services we now take for granted.