Eko India Financial Services has been named as one of FastCompany’s World’s 50 Most Innovative Companies, and #4 in India.
Amazon, Apple, Facebook, and Google are transformational firms, obsessions of the business world and deservedly so. But if you had to pick, which one would you say is the most innovative–literally, the most innovative company in the world? (And then who’s No. 2, No. 3, and No. 4?) The four we chose were featured on our cover last November (“The Great Tech Wars”). Since then, they have jostled for the No. 1 title–with Amazon’s Kindle Fire tablet, Apple’s Siri voice assistant, Facebook’s Timeline interface, and Google’s reinvention of YouTube as a niche-programming powerhouse. Yet each company has fallen victim to hubris, causing public-relations firestorms and some sloppy products.
The top slot can go to only one company, but why should we have all the fun deciding? Click the arrow to find quizzes, games, and brainteasers that can help you rate the Fab Four–measured from their wildest new ideas to their cultural cachet. Then see if your opinion matches ours. If it doesn’t, worry not. In a month or so, one of these firms will surely disrupt everything again.
Microfinance Focus, March 10, 2012: Mint conclave conference was held recently in New Delhi, India to discuss and debate about current situation and prospect of microfinance business. The event was organized by MINT, a leading Print Media with a joint collaboration between International Finance Corporation (IFC) and Microfinance Institutions Network (MFIN).
The conference panelists included Dr. K.P. Krishnan, Member, Secretary, Economic Advisory Council to the Prime Minister, J.K. Sinha, Chief General Manager, SBI, Samit Ghosh, MD, Ujjvan Microfinance, Jennifer Isern, Manager, Access Finance Advisory, South Asia (IFC), P.D. Rai MP and member of Financial Standing Committee along with Alok Prasad CEO of MFIN. The Session is moderated by Tamal Bandyopadhyay, Deputy Managing Editor of Mint.
During the conference, P.D. Rai, MP and Member of Financial Standing Committee said, “I am on the side of MFI”, and indicated that because of some bad apples the sector landed into crisis.
Dr. K.P. Krishnan, Secretary to the Economic Advisory Council to the Prime minister of India, said “The tendency of public policy and regulation is restrictive.” Further he said, “MFIs were a clear example. They were beginning to make a difference but I think the core ideological India hits back, it says ‘No’, There is only one model, we will decide what is good and hence you can see Andhra Pradesh ordinance.”
He further added, “You see the Malegam Committee recommendations, which variably talked off, I don’t have visionary control of growth therefore, and I am going to curb the growth”, He added. I think, “There has been a fundamental clash to handle development. There are more solutions there are possible what we tried out, in the past. Entire sector, to be hanged because there are some bad apples, “obviously it should not.” We need to figure out smartfully.”
Jayanth Sinha, Chief General Manager, SBI noted that earlier MFI was meant for social intention and later on it has turned into profit orientation. MFI should follow a responsible lending’.
Samit Ghosh, MD, Ujjvan, a Bangalore based Microfinance Company stated, “The role of microcredit has been oversimplified. That it will alleviate the poverty. But I think microfinance is a vehicle for the financial inclusion.”
Karnataka, India is a state where MFI is functioning really well and is a role model to the entire nation. MFIs in Karnataka have shown a best example to show coordinated work among the stakeholders and co-exist together, he added.
Jennifer Isern, Manager, Access Finance Advisory, South Asia (IFC) said, “IFC is very much optimistic about Microfinance. So much went right, lots of good work has been done, and it demonstrated way to do sustainable business.”
A stable peso and freer trade have allowed the majority of the population to escape poverty.
By MARY ANASTASIA O’GRADY
Tales of beheadings, bloody shootouts and execution-style murders in this country have overshadowed another story that, in the long view of history, is undoubtedly more significant. It is the rise of a Mexican middle class.
This little-noticed development is thanks not to government welfare or foreign aid but mainly to the opening of markets and to the end of the central bank’s practice of financing the government. Growth in the last decade has been nothing to brag about and key reforms are still needed if Mexico is to become a developed country. But as Banco de Mexico Governor Agustin Carstens told me over breakfast at the central bank here last month, institutional changes on the fiscal, financial and monetary fronts since the 1995 peso crisis have all contributed to increased price stability, a key factor in wealth accumulation.
One thing Mr. Carstens did not mention—since he is as diplomatically skillful as he is mindful of the high cost of inflation on Mexican households—is that Mexico has avoided running up huge fiscal deficits in recent years, despite a U.S. Treasury push for stimulus spending by the G-20. Mexico had been there and done that. When government goes hog-wild, markets worry that the debt will be monetized by the central bank. Mexican President Felipe Calderón of the National Action Party (PAN) wisely resisted.
ReutersA sale day at a Wal-Mart in Mexico City.
It was as much a political decision as it was economic. In a recently released book “Mexico: A Middle Class Society,” Mexican economist Luis de la Calle and Mexican political scientist Luis Rubio describe a nation where many politicians still think of the electorate as rural and poor but where consumption patterns reveal a trend toward urbanization and upward mobility. Judging by family incomes but also by things like housing rental and ownership, appliance purchases, Internet access and trips to the cinema, they argue that today “the middle-class population is the majority in Mexico.”
This has occurred, the authors say, “by combining the income of various family members [including remittances from abroad] rather than through the increased income of an individual or couple.” In other words, Mexico has not achieved the wage gains generally associated with a rising middle class.
So what’s different? For one thing, the North American Free Trade Agreement has meant an opening of the retail sector, giving Mexicans access to quality products at competitive prices. Second, family incomes are no longer being destroyed by successive devaluations and bouts of inflation triggered by fiscal crises.
The gains from this fiscal and monetary restraint are likely to have major implications for North American stability because, as Messrs. de la Calle and Rubio write, “In Mexico, the middle class has felt the consequences of the financial crises more than any other social group. It’s no coincidence that their political inclination is to be conservative and to reject any alternative that could destabilize their security.”
Mr. Carstens describes the process of “keeping a lid on inflation” as a “balancing act” because rising international commodity costs “generate upward pressure” on prices and so can peso weakness. The bank, he says, has tried “to keep [interest] rates as low as possible given [these constraints] in order to support as much as possible the economy.” It hasn’t been easy. Federal Reserve Chairman Ben Bernanke’s decision to flood the world with dollars has pushed food prices higher while financial scares around the globe—subprime and Europe—invariably send investors rushing out of currencies like the peso and into the dollar.
Mr. Carstens likes the “flexible” exchange rate-regime—in place since 1995—and credits it with allowing Mexico to adjust to shocks beyond its control while maintaining stability. But of course there are plenty of examples of flexible currency regimes that generate inflation. The real secret to Mexico’s inflation success, despite global financial turmoil, is an institutional commitment to fiscal discipline and transparency.
The central bank can now boast, as Mr. Carstens did to me, that it “adheres to all the best practices,” including publishing central bank minutes with a two-week delay. But it has also received help from the Mexican Treasury. Mexico now has a fiscal deficit of just over 2%, making it among the most fiscally restrained members of the Organization for Economic Cooperation and Development. Mexico’s ability to sell long-term bonds is a testimony to greater investor confidence.
Much more needs to be done. Politicians have rejected attempts to switch to countercyclical budgeting, which would imply saving for a rainy day some of the oil-bonanza proceeds generated by Mr. Bernanke’s easy money policy. How the Treasury will perform under future Mexican governments is far from clear. What is more certain is that the growing middle class won’t take kindly to the party or politician who next messes with their hard-earned gains.
For the first time ever, the number of poor people is declining everywhere
Mar 3rd 2012 | from the print edition
THE past four years have seen the worst economic crisis since the 1930s and the biggest food-price increases since the 1970s. That must surely have swollen the ranks of the poor.
Wrong. The best estimates for global poverty come from the World Bank’s Development Research Group, which has just updated from 2005 its figures for those living in absolute poverty (not be confused with the relative measure commonly used in rich countries). The new estimates show that in 2008, the first year of the finance-and-food crisis, both the number and share of the population living on less than $1.25 a day (at 2005 prices, the most commonly accepted poverty line) was falling in every part of the world. This was the first instance of declines across the board since the bank started collecting the figures in 1981 (see chart).
The estimates for 2010 are partial but, says the bank, they show global poverty that year was half its 1990 level. The world reached the UN’s “millennium development goal” of halving world poverty between 1990 and 2015 five years early. This implies that the long-term rate of poverty reduction—slightly over one percentage point a year—continued unabated in 2008-10, despite the dual crisis.
A lot of the credit goes to China. Half the long-term rate of decline is attributable to that country alone, which has taken 660m people out of poverty since 1981. China also accounts for most of the extraordinary progress in East Asia, which in the early 1980s had the highest incidence of poverty in the world, with 77% of the population below $1.25 a day. In 2008 the share was just 14%. If you exclude China, the numbers are less impressive. Of the roughly 1.3 billion people living on less than $1.25 a day in 2008, 1.1 billion of them were outside China. That number barely budged between 1981 and 2008, an outcome that Martin Ravallion, the director of the bank’s Development Research Group, calls “sobering”.
If China accounts for the largest share of the long-term improvement, Africa has seen the largest recent turnaround. Its poverty headcount rose at every three-year interval between 1981 and 2005, the only continent where this happened. The number almost doubled from 205m in 1981 to 395m in 2005. But in 2008 it fell by 12m, or five percentage points, to 47%—the first time less than half of Africans have been below the poverty line. The number of poor people had also been rising (from much lower levels) in Latin America and in eastern Europe and Central Asia. These regions have reversed the trend since 2000.
All this is good news. It reflects the long-run success of China, the impact of social programmes in Latin America and recent economic growth in Africa. It is also a result of the counter-cyclical fiscal expansions that many developing countries, notably China, embarked on in response to the 2007-08 crisis. Many economists (including some at the World Bank itself) were sceptical about these programmes, fearing they would prove inflationary, inefficient and ill-timed. In fact, the programmes helped make poor and middle-income countries more resilient.
The poverty data chime with other evidence. Estimates by the Food and Agriculture Organisation that the number of hungry people soared from 875m in 2005 to 1 billion in 2009 turned out to be wrong, and were quietly dropped. Derek Headey of the International Food Policy Research Institute has shown that despite the world food-price spike, people’s assessment of their own food situation in most poor and middle-income countries was better in 2008 than it had been in 2006.
Most of the progress has been concentrated among the poorest of the poor—those who make less than $1.25 a day. The bank’s figures show only a small drop in the number of those who make less than $2 a day, from 2.59 billion in 1981 to 2.44 billion in 2008 (though the fall from a peak of 2.92 billion in 1999 has been more impressive). According to Mr Ravallion, poverty-reduction policies seem to help most at the very bottom. In 1981, 645m people lived on between $1.25 and $2 a day. By 2008 that number had almost doubled to 1.16 billion. Even if many of these middling poor move up, their places are often taken by those who have just escaped from absolute poverty; population growth does the rest. The poorest of the poor seem to have escaped the worst of the post-2007 downturn. But the growth in the middling poor shows there is much to be done.
from the print edition | Finance and economics
Written By: Tom Murphy; Posted: 03/ 8/2012 3:09 pm
Original – http://www.aviewfromthecave.com/2012/03/using-microfinance-to-bring-clean-water.html
— A unique public-private partnership involving private sector giants like Unilever and Heinz is improving the health of Indian children. Two hours outside India’s tech hub Bangalore is Krishnagiri the Integrated Village Development Project
(IVDP) is using interest-free microfinance loans to increase access to products people could not afford on their own. “I care about the safe health and education of children. If I do business with people and don’t care, it is not development. This is not development,” explained Kulandei Francis
, founder of IVDP.
The term ‘microfinance’ elicits the image of groups of women who take loans, share the liability with the group members and use the money to expand a small business. This idea grew out of Nobel laureate Mohammad Yunus’s Grameen Bank which has operated in Bangladesh for four decades and reached a wider audience thanks to organizations like Kiva that allow any person to provide a microfinance loan to a woman anywhere in the world. Today, a shopper at Whole Foods can round up to the nearest dollar at the register to support the company’s microfinance institution of choice.
Microfinance is just about everywhere these days.
The truth is that microfinance is a complicated term that covers many ways people access financial services around the world. Payday loans in the United States are a form of microfinance — as is rainfall insurance for farmers in Ghana. It would be similar to calling every financial service that I can access in the United States ‘finance.’ It does not come close to adequately capturing the services I use.
In India, the most common avenue of accessing financial services by the poor is through self-help groups (SHGs). On the face they look similar to Yunus’s group lending scheme, but there are important differences that allow for a shift from building business to supporting social goods like health and education.
SHGs are formed by women with the help of an NGO. For a period of time, the women only save money. They deposit a small sum of 50 rupees ($1) each month. After six months, the women are eligible to take small loans. These loans can either come from the group savings account or through the bank. The group helps determine if the loan is appropriate for each member and serve as a check for the bank. Because the liability of the loan is shared among the group, it is in their interest to ensure that each member is capable of paying back a loan on time.
NGOs run Bank Linkage Programs to serve as an organizing mechanism and a bridge between the women and the banks. Having never been to a bank themselves, this bridge allows access, and provides an easy way of becoming familiar with banking. Additionally, the mission of the NGO is to ensure financial access for families so they can weather the peaks and valleys of poverty. The livelihoods of clients are at the forefront of NGOs like IVDP.
This small change in structure impacts how outcomes are then measured. For IVDP, success is measured by the health of children and their ability to go to succeed at school. To achieve this mission, IVDP partners with corporations like Unilever.
Unilever’s PureIt water filter is a significant innovation in terms of bringing safe water to homes in India. The device filters water to meet the US EPA standards for clean drinking water. It is simple to use and the most cost effective filter available.
IVDP partners with Unilever to provide women the ability to purchase a PureIt using an interest-free loan. She can pay for the 2000-rupee filter over time and has the ability to access future loans, still without interest, to pay for a new filter when it needs to be replaced. When I asked Mr. Francis why he would forgo the interest earned on the product he scoffed at the thought of collecting interest, “We do not take interest on anything that improves children’s health.”
I visited one SHG in Krishnagiri that is associated with IVDP. Of the 15 members in the group, 10 said they already owned a PureIt and two indicated that they are interested in purchasing one in the near future. The group leader bought the first PureIt about a year ago. A worker in a garment factory, she said that she used to do nothing to treat her water. When a family member fell ill, she would boil the water for them until they got better.
She understood that boiling water had a connection with illness, but did not do it as a precautionary measure. Since owning the PureIt, she says her children have been less sick and in school more often. In my time visiting both urban and rural users of PureIt, this change was observed by every mother. Their children were sick fewer days since drinking water from the PureIt and had improved attendance at school.
In another home, the PureIt was decorated with stickers. I remarked that it looked like the children liked the filter. She nodded saying, “The children maintain the PureIt and insist it is always clean”. She explained that her three sons and one daughter learned about clean water while at school and demanded that they have access to clean water. The mother, having learned about PureIt from her SHG and hearing the praise from the group leader, spoke with her husband and decided they would take out a loan to buy the filter.
Now, her children take a bottle of clean water with them to school each day. She did not know that germs were in her water and that they were making her family sick. She too was happy with the PureIt because it provided her good tasting water and her children were less sick. Only by seeing the product demonstration and learning about clean water from her children did she understand the importance of water safety.
Mr. Francis offers additional products to his clients including nutrition packets by Heinz and solar lamps from d.light. Such partnerships help to achieve his goal of improved health and education opportunities for the children of Krishnagiri. The group leader of the SHG uses one of the solar lamps. She charges it in her courtyard and said it is helpful during frequent blackouts so she can get around the house and her children can do their studies.
Recent studies and a book by David Roodman make it clear that microfinance has not been the transformative poverty solution as proponents claim. Giving families the ability to access financial services is important itself and support from NGOs to provide loans, like the interest free loan offered by IVDP to buy a PureIt, can bring about access to more products and services for the poor.
Wednesday, 07 March 2012 07:17
International Finance Corporation (IFC), the private sector investment arm of the World Bank Group, along with two other investors, will set up a $100 million debt fund called Micro Finance Initiative for Asia (MIFA), to address the funding needs of microfinance institutions in developing and underdeveloped economies. Final decision will be taken at the fund’s next board meeting to be held on April 9.
According to IFC, the MIFA Fund will be funded through 3 classes of shares. “Initially, the investors are expected to be IFC, KfW, and Bundesministerium für wirtschaftliche Zusammenarbeit und Entwicklung (German Federal Ministry for Economic Cooperation and Development,” an IFC release stated.
The fund has a target size of $100 million, including up to $25 million in donor-funded concessional funding. IFC’s investment in the fund is proposed to be up to $20 million in mezzanine shares.
The Luxembourg-based fund will set up special purpose vehicles in Mauritius and India. The fund will make its debt investments across Asia, including East, South and Central Asia.
“The project is in line with the IFC microfinance strategy for increased outreach in South, East and Central Asia, especially in large countries like India and China, home to 40 per cent of the world’s population. Microfinance penetration rates in this region remain among the lowest, globally,” the release said.
By supporting the expansion and sustainability of well-performing MFIs, the project will improve access to finance for thousands of micro and small borrowers. This, in turn, will stimulate growth, employment generation and poverty alleviation in the region.
IFC claims that the fund will facilitate access of Asian emerging market MFIs to commercial funding that is better tailored to their needs. It will reduce the volatility of MFI loan portfolios, as currently most MFIs are unable to properly address the currency mismatch risk. The fund also aims to provide longer-tenor funding and subordinated debt products, a clear need for MFIs at present.
In India, the Rs 23,000 crore microfinance industry has been under stress after the Andhra Pradesh government banned the exorbitant interest rates the institutions charge to small borrowers. The MFIs normally charge higher interest rates due to the higher cost of capital and higher risks involved with repayments of smaller loans.
According to the latest RBI data, bank lending to micro-credit through self-help groups or through NBFCs was less than 1 per cent of the total bank credit, amounting to around Rs 21,000 crore.
The Ghanaian branch of MicroEnsure, a UK-based subsidiary of nonprofit Opportunity International that serves as a microinsurance intermediary, has announced plans to offer credit health insurance to microfinance clients in Ghana. The product will enable MicroEnsure to cover weekly microcredit repayments in the event that the borrower is admitted to the hospital during the loan term. Clients will need to present proof of admission and discharge from a recognized inpatient hospital in order to file a claim. The cost of the coverage will start at USD 0.25 per month and will cover loan payments for any health condition for any amount of time.
According to Eugene Adogla, director of operations in Ghana, MicroEnsure expects to pay hundreds of claims that range between USD 30 and USD 60 each month. Fiona Laryea, general manager of MicroEnsure in Ghana, stated that MicroEnsure Ghana also hopes to extend coverage to clients’ families.
Two unnamed microfinance institution (MFI) partners of MicroEnsure Ghana have signed up for the new product, and more organizations have reportedly expressed interest.
MicroEnsure serves approximately 3.5 million poor clients in Ghana, India, Bangladesh, Mozambique, Malawi, the Philippines, Tanzania and Kenya as of 2011.
By Charlotte Newman, Research Associate
MicroEnsure was founded in 2005 in the UK as a wholly-owned subsidiary of Opportunity International, a US-based nonprofit microfinance network created in 1974. MicroEnsure was known as the Micro Insurance Agency until 2008. As an insurance intermediary, it provides a range of products including health, life, property and weather index-based insurance to approximately 3.5 million poor clients in Ghana, India, Bangladesh, Mozambique, Malawi, the Philippines, Tanzania and Kenya as of 2011.
Playing with fire
Financial innovation can do a lot of good, says Andrew Palmer. It is its tendency to excess that must be curbed
Feb 25th 2012 | from the print edition
FINANCIAL INNOVATION HAS a dreadful image these days. Paul Volcker, a former chairman of America’s Federal Reserve, who emerged from the 2007-08 financial crisis with his reputation intact, once said that none of the financial inventions of the past 25 years matches up to the ATM. Paul Krugman, a Nobel prize-winning economist-cum-polemicist, has written that it is hard to think of any big recent financial breakthroughs that have aided society. Joseph Stiglitz, another Nobel laureate, argued in a 2010 online debate hosted by The Economist that most innovation in the run-up to the crisis “was not directed at enhancing the ability of the financial sector to perform its social functions”.
Most of these critics have market-based innovation in their sights. There is an enormous amount of innovation going on in other areas, such as retail payments, that has the potential to change the way people carry and spend money. But the debate—and hence this special report—focuses mainly on wholesale products and techniques, both because they are less obviously useful than retail innovations and because they were more heavily implicated in the financial crisis: think of those evil credit-default swaps (CDSs), collateralised-debt obligations (CDOs) and so on.
In this special report
This debate sometimes revolves around a simple question: is financial innovation good or bad? But quantifying the benefits of innovation is almost impossible. And like most things, it depends. Are credit cards bad? Or mortgages? Is finance as a whole? It is true that some instruments—for example, highly leveraged ones—are inherently more dangerous than others. But even innovations that are directed to unimpeachably “good” ends often bear substantial resemblances to those that are now vilified.
For a demonstration, look at Peterborough. The cathedral city in England’s Cambridgeshire is known for its railway station and an underachieving football club nicknamed “the Posh”. But it is also the site of a financial experiment that its backers hope will have big ramifications for the way public services are funded.
Peterborough is where the proceeds of the world’s first “social-impact bond” are being spent. This instrument is not really a bond at all but behaves more like equity. In September 2010 an organisation called Social Finance raised £5m ($7.8m) from 17 investors, both individuals and charities. The money is being used to pay for a programme to help prevent ex-prisoners in Peterborough from reoffending. Reconviction rates among the prisoners recruited to the scheme will be measured against a national database of prisoners with a similar profile, and investors will get payouts from the Ministry of Justice if the Peterborough cohort does better than the rest. If all goes well, the first payouts will be made in 2013.
The scheme is getting lots of attention, and not just in Britain. A mixture of social and financial returns is central to a burgeoning asset class known as “impact investing”. Linking payouts to outcomes is attractive to governments keen to husband scarce resources. And if service providers like the people running the Peterborough prisoner-rehabilitation scheme can get a lump sum up front, they can plan ahead without bearing any financial risk. There is talk of introducing social-impact bonds in Australia, Canada and the United States.
Here, surely, is a financial innovation that even the industry’s critics would agree is worth trying. Yet in fundamental ways an ostensibly “good” instrument like a social-impact bond is not so different from its despised cousins. First, at its root the social-impact bond is about creating a set of cashflows to suit the needs of the sponsor, the provider and the investor. True, the investors in the Peterborough scheme may be more willing than the average individual or pension fund to sacrifice financial returns for social benefits. But as Franklin Allen of the Wharton School at the University of Pennsylvania and Glenn Yago of the Milken Institute, a think-tank, argue in their useful book, “Financing the Future”, the thread that runs through much wholesale financial innovation is the creation of new capital structures that align the interests of lots of different parties.
Second, the social-impact bond is based on the concept of risk transfer, in this case from the government to financial investors who will get paid only if the scheme is successful. Risk transfer is also one of the big ideas behind securitisation, the bundling of the cashflows from mortgages and other types of debt on lenders’ books into a single security that can be sold to capital-markets investors. The credit-default swap is an even simpler risk-transfer instrument: you pay someone else an insurance premium to take on the risk that a borrower will default.
Third, even at this early stage the social-impact bond is grappling with the difficulties of measurement and standardisation. An obvious example is the need to create defined sets of measurements in order to work out what triggers a payout—in this case, the comparison between the Peterborough prisoners and a control group of other prisoners in a national database. Across finance, standardisation—around contracts, reporting, performance measures and the like—is what enables buyers and sellers to come together quickly and new markets to take off.
Neither angels nor demons
For all the similarities, there are two big differences between the social-impact bond and other, less lauded financial instruments. The first is that the new tool has been designed explicitly for a social purpose. But ask a pensioner how much money he wants to put into prisoner rehabilitation, and it isn’t likely to be all that much.
Whether protecting a retirement pot or signalling problems with a government’s debt burden, finance can be “socially useful” (to use a phrase popularised by Adair Turner, the outgoing chairman of Britain’s Financial Services Authority) without being obviously social. Lord Turner himself acknowledged that in a speech he gave in London in 2009: “It is in the nature of markets that there are some things which are indirectly socially useful but which in the short term will look to the external world like pure speculation.”
Many people point to interest-rate swaps, which are used to bet on and hedge against future changes in interest rates, as an example of a huge, well-functioning and useful innovation of the modern financial era. But there are more contentious examples, too. Even the mention of sovereign credit-default swaps, which offer insurance against a government default, makes many Europeans choke. There are some specific problems with these instruments, particularly when banks sell protection on their own governments: that means a bank will be hit by losses on its holdings of domestic government bonds at the same time as it has to pay out on its CDS contracts. But in general a sovereign CDS has a useful signalling function in an area tilted heavily in favour of governments (which do not generally have to post collateral and can bully domestic buyers into investing).
When bubbles froth, innovations are used inappropriately—to take on exposures that should not have been, to manufacture risk rather than transfer it, to add complexity
The second difference is that social-impact bonds are still in their infancy, whereas other crisis-era innovations were directly involved in a gigantic financial crisis. There are questions to answer about their culpability. A few products from that period do look inherently flawed. Only the bravest are prepared to defend the more exotic mortgage products that sprouted at the height of America’s housing bubble as lenders found ever more creative ways to bring unaffordable houses within reach. Finance professionals almost blush to recall an instrument called the constant-proportion debt obligation, a 2006 invention of ABN AMRO that added leverage when it took losses in order to make up the shortfall. The end of the structured investment vehicle (SIV), an off-balance-sheet instrument invented to game capital rules, is not much lamented. And the complexity of the “CDO-squared” has been widely condemned.
But even now it is hard to find fault with the concept, as opposed to the practical application, of many of the most demonised products. The much-criticised CDO, which pools and tranches income from various securities, is really just a capital structure in miniature. Risk-bearing equity tranches take the first hit when things go wrong, and more risk-averse investors are more protected from losses. (Euro-zone leaders like the idea enough to have copied it with their plans for special-purpose investment vehicles for peripheral countries’ sovereign debt.) The real problem with the CDOs that blew up was that they were stuffed full of subprime loans but treated by banks, ratings agencies and investors as though they were gold-plated.
As for securitisation and credit-default swaps, it would be blinkered to argue they have no problems. Securitisation risks giving banks an incentive to loosen their underwriting standards in the expectation that someone else will pick up the pieces. CDS protection may similarly blunt the incentives for lenders to be careful when they extend credit; and there is a specific problem with the way that the risk in these contracts can suddenly materialise in the event of a default.
But the basic ideas behind both these two blockbuster innovations are sound. India, with a far more conservative financial system than America, allowed its first CDS deals to be done in December, recognising that the instrument will help attract creditors and build its domestic bond market. Similarly, securitisation—which worked well for decades—allows banks to free up capital, enabling them to extend more credit, and helps diversification of portfolios as banks shed concentrations of risks and investors buy exposures that suit them. “Securitisation is a good thing. If everything was on banks’ balance-sheets there wouldn’t be enough credit,” says a senior American regulator.
Rather than asking whether innovations are born bad, the more useful question is whether there is something that makes them likely to sour over time.
Greed is bad
There is an easy answer: people. When bubbles froth, greedy folk use innovations inappropriately—to take on exposures that they should not, to manufacture risk rather than transfer it, to add complexity in order to plump up margins rather than solve problems. But in those circumstances old-fashioned finance goes mad, too: for every securitisation stuffed with subprime loans in America, there was a stinking property loan sitting on the balance-sheet of an Irish bank or a Spanish caja. “Duff credit analysis is always the cause of the problem,” says Simon Gleeson of Clifford Chance, a law firm.
This argument has a lot of power. When greed takes hold, finance in all its forms is undone. Yet blaming the worst outcomes of financial innovation on human frailty is hardly helpful. This special report will point to the features of financial innovations that can turn them into troublemakers over time and show how these can be managed better.
In simple terms, finance lacks an “off” button. First, the industry has a habit of experimenting ceaselessly as it seeks to build on existing techniques and products to create new ones (what Robert Merton, an economist, termed the “innovation spiral”). Innovations in finance—unlike, say, a drug that has gone through a rigorous approval process before coming to market—are continually mutating. Second, there is a strong desire to standardise products so that markets can deepen, which often accelerates the rate of adoption beyond the capacity of the back office and the regulators to keep up.
As innovations become more and more successful, they start to become systemically significant. In finance, that is automatically worrying, because the consequences of any failure can ripple so widely and unpredictably. In a 2011 paper for the National Bureau of Economic Research, Josh Lerner of Harvard Business School and Peter Tufano of Said Business School also argue that in a typical “S-curve” pattern, in which the earliest adopters of an innovation are the most knowledgeable, a widely adopted product is more likely to have lots of users with an inadequate grasp of the product’s risks. And that can be a big problem when things turn out to be less safe than expected.