Innovation in financial product development has received a lot of criticism in the wake of the recent financial crisis in the developed economies of the world. It has been blamed for the contagion one may observe in the well-developed financial markets around the world. Financial derivatives and structured products in particular draw a major share of this criticism. Consequently, financial regulators have gone back to their drawing boards to redraw regulatory maps to restrict what is being termed as irresponsible innovation.

Given this focus on innovation and a born-again urge for regulation, let us ponder the optimum levels of regulation and innovation to ensure that growth in the financial sector is not unnecessarily hampered by over-regulation.

There is no denying the fact that the current financial crisis has shaken the foundations of the western capitalist system; yet almost all economies of the world, including those of China and other emerging nations, look upon the western model of regulation for devising national policies to regulate and run their financial systems.

The western approach to liberalisation of the financial sector in the last 20 years or so resulted in an influx of new products that benefited different stakeholders (including consumers of financial services) immensely. When things went wrong, some suggested revisiting the entire system to identify the factors that contributed to the current mess and chaos many countries find themselves in.

Although there is a widespread perception that innovative and over-sophisticated product offerings were the main factors triggering the crisis, it is equally true that financial regulators did not perform their jobs properly. Almost everything, including risk assessment at the product or institutional level, was left to the market so that it could perform smoothly to the benefit of all stakeholders. This proved to be deadly, as individuals and institutions ended up pursuing narrow interests, while consumers ended up using financial services excessively and imprudently. Thus, while financial innovators did a bad job, regulators also failed to perform their duties diligently and properly.
One message that one may draw from experience of the last 20 years of financial innovation is that moving the financial sector away from the real economy is not a good idea at all. Islamic economists have been arguing for the last 30 years against the dichotomy between the financial sector and real economic activity. Any innovation that involves trading in debt (eg, creating debt from debt and buying and selling debt instruments), over-reliance on insurance (ie shifting risk from one party to another in the financial markets without actually reducing the volume of risk), and creating money through an interest-rate mechanism is bound to result in financial bubbles that destabilise the economic system.

On a systemic level, any kind of budget deficit (especially large government budget deficits) is not self-sustainable and, hence, caution must be exercised before over-spending. Any innovation in financial services which encourages spending first to save later is dangerous and has adverse implications for future generations. It is, therefore, important to encourage savings with the help of innovative financial products so that future generations benefit from the savings of their predecessors.

One such model could be based on the idea of micro-savings and micro-investments. While microfinance has been used as a tool for promoting financial inclusion in a number of countries, it is time now to develop micro-investment programmes that encourage individuals and households to save small amounts over significantly long time periods.

These small savings and micro-investments can be encouraged with the help of strong incentivisation programmes. Prizes and rewards are one way of encouraging people to save more and for longer time periods. Prize-based saving schemes and loyalty programmes as devised by businesses (eg air miles, reward points, etc) may be used to structure innovative financial products.

It is important that strong regulatory frameworks are developed for long-term micro-savings and investments, to ensure safety of such savings by investing them prudently in long-term infrastructure projects. In most developing countries, including many emerging markets, legal structures and property rights regimes are either non-existent or underdeveloped. Hence, governments must focus on bringing legal reforms to accommodate such a change. This will indeed give rise to a new range of financial products that will not only deepen financial markets, but also create and maintain the desired link between finance and economy.

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