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Re-thinking Financial Systems Design in India

The first IFMR Financial Systems Design Conference was held in Chennai on August 5th and 6th, 2011. Hosted by IFMR and IFMR Finance Foundation, the conference aimed to take a step back from specific institutional frameworks, products and regulatory architectures and take a more fundamental and functional view of the financial system, and thereby attempt to understand what can be done to improve the ability of the Indian financial system to fulfil its functions effectively. The conference brought together a group of leading researchers and practitioners in the Indian financial system. In his introductory remarks, Dr. Nachiket Mor observed that “we are at a time when many of the historic imperatives which led to the current design of our financial systems are perhaps no longer valid and that, as a uniquely advanced but also very poor country urgently in need of sustained and rapid growth and development, we have the opportunity to do things in a way that other countries do not.”

To provide some context, while the Indian financial system has steadily evolved over the years, it continues to lag behind in terms of size (financial firms growing much slower than needs of the real economy), spread (80% of Indian villages do not have a bank branch in a 2 KM radius, more than 50% of small business financing happens through informal sources), scope (roughly 50% of the population has a bank account, about 10% have life insurance and less than 10% participate in equity markets in any form), innovation (securitisation, credit derivatives and corporate bond markets are tiny) and diversity of ownership (largest financial firms are Government owned).

In order to best facilitate the discussions, the conference was broken up into three segments; Origination, Risk Transmission and Risk Aggregation as three broad buckets of questions and concerns – one involving customers and customer protection issues, the other involving markets and derivatives and the third involving large, nationally important financial institutions and systemic risk concerns. Following a lead presentation for each of the three broad buckets, each table came up with vision statements for that theme which were then shared across the room and discussed. Following the visioning, there was an exercise to identify the pathways for to arrive at the desired end-state. These pathways were categorised into Research, Regulation, Innovation and Public Infrastructure.

Origination: Ensuring Positive Financial Outcomes for Customers

The Origination session highlighted that we were very far from universal availability of the two core functions of finance: liquidity and risk management for households and firms in India. In discussing the present landscape of Origination in India, conference participants concluded that although there is diversity among Originators, it is dominated by manufacturers (Commercial Banks, Insurance companies, mutual funds) who engage in Origination. Financial services get delivered to the end-customer in a disaggregated manner, with the customer being made responsible ex-ante through financial literacy with almost no ex-post responsibilities on the Originators. There is therefore no formal customer protection regulation, and regulations being put in place have been based on institution-types such that these regulations are often overlapping. The vision identified for Origination was “a financial system in which there are multiple and diverse Originators providing integrated financial services to individuals, households and firms, evaluating and pricing risks appropriately, and ultimately taking responsibility for good financial outcomes for customers.”

Risk Transmission: Finding Effective Mechanisms to Transfer Risk

The Risk Transmission session evaluated products and markets that allowed households and firms, particularly financial institutions, to transfer risk. While important steps have been taken, participants felt that building risk transmission markets must continue to be an important financial policy objective. From a legal perspective, development of good resolution mechanisms is integral to the development of risk transfer markets. While the SARFAESI Act has been beneficial for banks vis-a-vis corporate lending, a lot more work is required on this front. Participants also noted the near total absence of thinking on the issue of household/personal bankruptcies, and the need to meet unaddressed risks, such as inflation. The vision statement that emerged for this function was “To design, develop and sustain effective mechanisms that enable transfer of risk from households and originators to institutions than can better manage these risks.”

Risk Aggregation: Developing Aggregators Able to Manage Risk Safely

Finally, the Risk Aggregation session examined the robustness of large financial institutions in India and their ability to successfully warehouse and manage risk. The two critical points noted in this session were that a) India did not have sufficiently large financial institutions given the needs of its real economy b) government ownership of most systemically important institutions, while seemingly staving off crises, were also blunting incentives for good risk management. The vision statement here was “a financial system where Aggregators are numerous enough, large enough, and have the risk management capabilities to evaluate, price, hold and manage the diversity of risk originated from the real economy.”

At the end of the two days of discussions, key-takeaways were identified. Some of the research questions identified include:

a) What are the trade-offs, if any, between financial inclusion and systemic risk? Are there particular models of financial inclusion that fare better than others as viewed from this perspective?

b) Financial advice as a function of originators. How is this best structured? What liability must the originator have for advice provided to clients? How must financial advisors be compensated?

c) Are there market based instruments (ex: listed subordinate debt) that provide additional information regarding the health of systemically important financial institutions? Can these effectively supplement supervision-based information?

d) Does structuring Government ownership in financial institutions differently reduce distortionary effects as a second-best measure to privatisation? For ex: holding company structure to channel all Government investments into financial institutions versus direct Government investments into specific financial institutions.

We welcome collaborations from researchers interested in these issues.