Financial innovation needs to address problems of the 21st century and embrace larger social issues, says Sanjay Banka

The financial markets are a part of changing business paradigms across the world and are increasingly the first to unleash creativity leading to innovation. Cut throat competition in international markets with a focus to enhance stakeholders’ value is exerting immense pressure on their CFOs to invent and innovate. Be these new products, new processes, new strategies, and even new possibilities. Thus financial markets continue to get redefined, reinvented, and reconfigured. Financial innovation - like innovation elsewhere in society - is an ongoing process whereby players (read CFOs), differentiate their products and services, responding to perceived future trends.

What is innovation? The National Knowledge Commission headed by Sam Pitroda has defined innovation as, “A process by which varying degrees of measurable value enhancement is planned and achieved, in any commercial activity. This process may be breakthrough or incremental, and it may occur systematically in a company or sporadically; it may be achieved by introducing new or improved goods or services or by implementing new or improved operational processes, or implementing new or improved organisational and managerial processes in order to improve market share, competitiveness, and quality, while reducing costs.” A financial innovation represents something new that reduces costs, mitigates risks, or provides an improved product, a service, or an instrument that better satisfies participants’ demands (See Figure 1).

The HuF is a unique financial innovation that can be truly credited to India, while there is a somewhat similar provision in the US where husbands and wives can file joint tax returns

Financial innovation model

Figure 1 shows a model of Financial Innovation exhibiting new products (for example, adjustable-rate mortgages and exchange-traded index funds); new services (for example, online securities trading and internet banking); new processes (for example, electronic record-keeping for securities and credit scoring); new organisational forms (for example, a new type of electronic exchange for trading securities and internet-only banks); or even new forms of taxation (like Fringe Benefit Tax, Dividend Distribution Tax, and Retrospective Taxation). Sometimes terms like ‘Financial Engineering’ are used interchangeably with innovation; however, there is a clear demarcation between the two. Financial Engineering refers to fine-tuning existing resources, or deploying existing financial products, or resources to achieve the goals of an entity. Similarly, schemes like the ‘Ponzy Scheme’ or ‘Plantation Scheme’ are not innovations, but a ploy to dupe investors.

Innovations since the last century

Undoubtedly, the last few decades have seen the emergence of several innovative financial instruments (See Figure 2) including Bonus Debentures, Commercial Papers (CP), Certificate of Deposits (CD), Cumulative Convertible Preference Shares (CCPS), Sukuk Bonds, Foreign Currency Convertible Bonds (FCCBs), Foreign Currency Exchangeable Bonds (FCEBs), Depository Receipts (GDRs, ADRs, IDRs), and Stockinvest, among others. Each of these instruments had a compelling reason for its evolution. Some innovations became obsolete within a short span of time like Stockinvest, while others like the FCCBs and Depository Receipts have stood the test of time. The Differential Voting Right (DVR) shares, is another financial innovation to enable retail investors to invest at a lower price while allowing promoters to retain a controlling stake. The Zero Coupon Bond (ZCB) came into existence as a tax-saving device. Hindustan Unilever Limited (HUL) was the first Indian company to issue Bonus Debentures, followed by AstraZeneca, and Britannia. The Fringe Benefit Tax (FBT) was a short-visioned innovation which held corporates to ransom for over four years, until it was sent to its grave. Such innovations by Governments which are intended to fleece corporates do not have a long shelf life. On taxation innovation, the visionary introduction of the Service Tax in 1996 is laudable, when the Indian economy transited from being agrarian-based. It has achieved its adulthood, and now covers almost all conceivable services apart from those services on the negative list and the exempted list.

Inventions catch on and spread like an epidemic at tremendous speed. Credit Default Swaps which were innovated in the 1990s had a notional value of USD 62.2 trillion by 2007. Exchange Traded Funds (ETFs) quickly grabbed people’s attention especially the gold funds which afforded opportunity to investors to hold precious commodities in demat form. Currency and interest-rate swaps allow global corporations to focus on their core businesses without having to worry about wild swings in currency values. Index funds have given individual investors a low-cost way of putting their money to work.

The 2012 Dufrenoy Prize jury lauded the Indian regulatory approach for being precautionary and gradual, with a culture of testing and paying attention to potential negative effects of sophisticated financial products before facilitating them

Organisation structures have also undergone innovation: The Limited Liability Partnership (LLP) has been hailed as a major improvement in the partnership form of organisation, and has enticed the world, especially India. Asset Reconstruction Companies (ARC) evolved to tackle problems of non-performing assets (NPAs). The Hindu Undivided Family (HuF) is a unique financial innovation that can be truly credited to India, while there is a somewhat similar provision in the US where husbands and wives can file joint tax returns. Venture Capital provides startups and established businesses the opportunity to raise short term equity funds with ease. Microfinance (MFI) is an organisation form which emerged to cater to the capital needs of marginalised sections of society and Muhammad Yunus of Bangladesh received the Nobel Peace Prize along with the Grameen Bank in 2006, for his exceptional contribution in this field. However, in India, MFIs were seen as exploiting the poorer sections, and the YH Malegam Committee was set up to look into the matter. What followed is stringent regulations were imposed by the RBI, which has dealt a body blow to MFIs.

Similarly, the development of Futures, Options, Swaps and their extension to Forex Products and commodities has been well received. Arguably, the single largest innovation in the global financial markets in response to financial deregulation and financial innovation over the past two decades has been the emergence and spectacular growth of the derivatives markets. New forms of markets have also evolved due to financial innovation along with market intermediaries that were unheard of earlier. Starting with the modest Stock Market, it sprang branches in the form of the Commodities Market, followed by Electricity Exchanges.

Since finance is a facilitator of virtually all commercial and economic activities, every financial innovation has a cascading effect with ramifications across the economy. These encourage more savings and investment, leading to better utilisation of private and public resources, thus supporting value creation. As with all other innovation, financial innovations also incentivise investment and consumption by creating enthusiastic expectations from the innovation. However, greedy and visionless innovation may also lead to financial bubbles being formed and the untimely demise of the instrument.

In contrast to scientific inventions and innovation which are the subject matter of patents and IPR, financial innovations are more secular and open to replication globally, without any IPR restrictions. Thus, when the world took the lead in issuing Global Depository Receipts (GDRs), it did not take the Americans long to introduce their own brand in the form of the American Depository Receipt (ADR), and Indians with their Indian Depository Receipt (IDR).

The drivers of innovation

The key drivers of innovation are technological advancements like the Internet, supercomputing capacities, growth in global trade and commerce, and higher expectations from users of financial systems. Technology advancements have resulted in the invention of a rainbow of financial products like the Exchange Traded Funds (ETFs) and Online Trading and Dematerialisation. Financial innovations are also driven by regulatory changes and tax planning. Many times regulatory obstacles also motivate CFOs to innovate and Indian enterprises have often adopted this route of innovating complex products to overcome domestic restrictions. Products like the Bonus Debenture, Optionally Fully Convertible Debentures (OFCD) scheme, or tax-saving entities like the HuF, have evolved due to tax obstacles posed by regulators. But to succeed and sustain in the long term, a financial innovation needs to be simple, cost effective, regulatory compliant, and must result in economic benefit (See Figure 3).

The enemies of innovation History is replete with examples of progress in economic development achieved over several decades, getting wiped out by a financial crisis in just weeks or months. The subprime crisis in the US was caused due to mindless financial innovation with ulterior motives. The Indian innovation of priority sector lending due to political vote bank criteria is similar in nature, and continues to mar the Indian economy. The biggest enemies of financial innovation are governments and regulators. They continue to look at these products with suspicion and introduce regulatory amendments to crush such innovations. Especially those which they think have been framed to avoid taxes or compliance. The most recent case is the Sahara Group’s issuance of the OFCD, without seeking approval from stock market regulator SEBI, and in August 2012, it was annulled by the Supreme Court. The apex court ordered the Sahara Group to refund over Rs 24,000 crore that it had collected from over 29 million investors, through this route. Tax laws and the lack of technology support also hinder innovation. Taxation innovations like the FBT introduced by Governments, based on sheer greed, also do not last long. Innovation in financial reporting is also a very dangerous trend which led to the fall of Satyam, Worldcomm, Tyco, and Enron.

One of the most formidable challenges for CFOs continues to be funds availability and the securitisation process - and this should be top priority for financial scientists

The credit derivative was hailed as a great innovation, but suffered a severe jolt in 2008, with the collapse of Bear Stearns in the US, which was a counter party to USD 13 trillion in derivative trades which is almost equal to the US GDP. Derivatives have earned the dubious distinction of being Weapons of Mass Destruction (WMD), but this is an irony. If society uses an innovative product for unfair gains, it cannot blame the innovation. An enormous challenge faced by financial scientists and CFOs is the lack of recognition by society. Several innovations made by CFOs go unsung and unnoticed.

Has India underperformed on financial innovation?

Liberalisation and globalisation of the Indian economy has fast-tracked India’s integration with the global financial markets and the culture of innovation. India may not have performed greatly in innovating but we have been quick to adapt financial innovations made worldwide. India’s apex bank the Reserve Bank of India (RBI) along with other sectoral regulators like SEBI, IRDA, PFRDA, the stock exchanges, and professional accounting bodies have continuously supported financial innovation. Reliance Industries became the first Asian company to issue a 100-year Yankee Bond in the US. Indian entities have also been using hybrid instruments like the FCCB extensively to raise funds globally, though this has a huge downside today. When the world was riding high on depository receipts since the early 20th century, India belatedly permitted its entities to raise GDR and ADR funds by the 1980s. India also introduced its own version of the Depository Receipt, the IDR which has however, not taken off well with only Standard Chartered Bank issuing its IDR. Exchangeable Bonds are issued worldwide, but India has a dismal record in adopting this. Credit Default Swaps which exceeded USD 700 trillion in volume globally (almost 10 times the global GDP), were launched in India in 2011, but has not been successful.

The Indian banking system and the stock trading system have recently been lauded as being among the most advanced systems in the world. The credit for this goes to the Bombay Stock Exchange (BSE), and the National Stock Exchange (NSE), for using IT platforms extensively to support financial innovation. This is particularly true for India’s banking system, which has in the past decade introduced mobile, and internet banking, no-frills accounts, loan securitisation, and business correspondents (agents in far-flung areas). This was in tandem with the nationwide computerisation of bank branches, through the implementation of core banking solutions (CBS), and an enormous increase in the number of automated teller machines (ATMs).

On the flip side, the innovation of regional stock exchanges did not take off well, and with the advent of the NSE almost all regional stock exchanges (except BSE) are on the path of extinction. MFIs were meant to foster financial inclusion but were dealt a body blow – but there is a need to support this innovation to provide capital to the poor.

There is a need to innovate a platform, possibly, an institution which can hold mortgaged securities in demat form and make them freely transferable. This will ease the process of borrowing and save on the enormous time spent on documentation

Recently, the RBI was awarded the 2012 Dufrenoy Prize for its precautionary approach in regulating the derivatives market, and thus facilitating financial innovation in a responsible manner. This prize was instituted by the Observatory for Responsible Innovation (ORI) – an independent international think tank with the purpose of thinking and debating on new measures, concepts, and methods to foster responsibility in innovation. The jury lauded the Indian regulatory approach for being precautionary and gradual, with a culture of testing and paying attention to potential negative effects of sophisticated financial products before facilitating them. This encapsulates the culture and methodology of the RBI as it seeks to fulfil its mandate – and juggles the multifarious roles assigned to it – of maintaining stability of both prices and the financial system, and supporting economic growth.” It is interesting to note that the Indian ‘Jugaad’ culture which has become a subject matter of research of scholars worldwide has been further fine tuned by the National Knowledge Commission as the ‘Tod Fod Jod’ (TFJ) initiative. It is hoped that the TFJ approach will help our CFOs to also innovate further.

Future trends

Innovations are not for the pusillanimous! One of the most formidable challenges for CFOs continues to be funds availability and the securitisation process – and this should be top priority for financial scientists. There is a need to innovate a platform, possibly, an institution which can hold mortgaged securities in demat form and make them freely transferable. This will ease the process of borrowing and save on the enormous time spent on documentation. The financial scientists must also find a solution to the menace of ‘hedging cost’ which can make foreign currency borrowing cheaper and enable the free flow of cheap capital to developing economies. A common currency for the ASEAN and BRICS economies is a dream which can be converted by innovators into reality to facilitate international trade. Today, promoters’ holdings are managed by a maze of hundreds of holding companies and this has to be checked with definitive regulatory innovation only.

Another big challenge, and perhaps the biggest, is to rein in the menace of black money which is now estimated to have reached the size of USD 500 billion. The Finance Minster as the CFO of India has to make innovative tax laws to bring back this money from the tax havens.

Conclusion

Financial innovation is often viewed by the government and regulators with skepticism as they believe that these are mostly designed for tax avoidance and to skirt regulatory compliance. Financial innovation presupposes unbundling and rebundling of risks. Thus a mature regulatory framework should seek to set up enough bulwarks and resilience in the system, instead of hindering innovation itself. The regulatory and supervisory ecosystem must also keep pace with innovation, by hiring skilled and top-notch professionals, who should be ahead of the professionals they supervise, to make innovation a participative process. There is also a strong need today to foster a new equilibrium between our past innovations and future needs. For financial innovation to take place there has to be a high level of dissatisfaction with the present and concern over future needs.

Financial scientists, regulators, and CFOs must transcend beyond finance and look into the problems and challenges of the 21st century. These are the challenges of inclusive growth, environmental risk, and lack of funds for marginalised classes. Financial innovation should not be stereotyped into developing financial instruments, processes, and reporting norms, but embrace larger social issues to meet the demands of society.