It’s hard to say if former US Federal Reserve chairman Paul Volcker was joking when he noted in December that the peak of innovation in finance was the automated teller machine, or ATM. With his ringside view to the last 30 years of financial history, his point is that most innovative products can often be the build-up to the next financial crisis.
On Tuesday, Securities and Exchange Board of India chairman C.B. Bhave expressed similar doubts: Financial products are often disguises for taking on leverage or debt. And the more the leverage, the harder the fall.
What took the modern financial world until late 2008 to realize—once every Western household had discovered credit-default swaps (CDS) to be “weapons of mass destruction”—US economist John Kenneth Galbraith had noted as early as 1993. Bhave is channelling Galbraith’s words: “All financial innovation involves, in one for or another, the creation of debt secured in greater or lesser adequacy by real assets.”
Consider the history of financial innovation in the 1980s that Galbraith was looking back at. The two big developments of that decade were the mortgage-backed security (which allowed home loans to be bought and sold like any other bond) and the junk bond (which allowed companies with shaky fundamentals to raise lots of money). Both were perfected the same time, and both ended up signalling the worst of that decade’s financial excesses. Mortgage securities meant savings and loan banks sold off more home loans, enlarged their balance sheets, and then collapsed. Junk bonds meant corporate raiders acquired any and all companies through leveraged buyouts.
That time around, the world financial system survived. But the last decade’s excesses almost rang a systemic death knell. Mortgage securities were once again leveraging the system, while CDS—insurance against a debt’s default—meant that firms could load up on more debt, assuming they were protected against default.
That’s the history facing regulators in India now. To their credit, they have been cautious about products such as CDS, so as to allow safe amounts of leverage in the system. In 2008, the Reserve Bank of India stymied the introduction of CDS. But late last year, when the financial coast was clear, it signalled interest in it again.
We hope its sense of caution will continue to prevail.
Is there an upside to financial innovation? Tell us at firstname.lastname@example.org