Can there ever be too much innovation? The global financial system seems to have hit a wall on developing novel ideas.
By Piya Mahtaney
In this post in the CSRwire series on Globalization and Sustainable Economic Development, we discuss why financial innovation has not led to significant financial development.
Profound changes have occurred in the global financial system over the preceding three decades. The impact on business has been decisive. Financial reform is a compelling priority for expanded financial development.
Financial Development: Too Little of It
The WEF Financial Development Report (2011) defines financial development as “the factors, policies, and institutions that lead to effective financial intermediation and markets, as well as deep and broad access to capital and financial services.’
As recent empirical evidence has shown, the focus of most financial innovations has been regulatory arbitrage. This is one of the main causes that led to the crisis. If the expanded availability of finance capital enabled by the increasing size of financial markets had also been accompanied by the process of risk minimization and a greater diversification of the financial system, the challenges that confront the world would not be as serious and as deeply seated. (By regulatory arbitrage we mean escaping the purview of regulatory mechanisms or circumventing regulation.)
A more diversified composition of financial innovation directed towards expanding the availability and access to developmental finance would have made a larger contribution to financial development.
Instead of increasing productive investment, driven liberalization led to a reduced proportion of wage incomes. As such, it inhibited the use of household savings for capacity building investment projects, and, in fact, funded and fueled speculative and other unproductive forms of expenditure.
Since the 1990s it has been evident in most countries that patterns of consumption and investment supported by finance driven liberalization would not foster inclusive development. Consequently, the financial system became disembodied from its fundamental role of serving the imperatives of the real sector and began to operate in a constellation of deregulated financial markets, mounting leverage and speculative excesses.
Inequality of Access Hurts Investors, Development
The evidence over past decades shows that sharp inequities in accessing finance – and through it other forms of capital – whittle down the prospects for development.
The instruments of any country’s financial system can be manipulated with greater ease and guile by special interest groups through weak enforcement of investors’ rights and a lack of transparency and unclear demarcations between public and private interests.
At the base of this skewed control of the financial system is the collusion between public policy and vested interests—but at which point of this collusive behavior public policy becomes inept and extremely limited is not easy to gauge.
Inevitably, restoration of stability in a global financial system that is recovering from the crisis would be assigned precedence over all other considerations. Yet, it is important that this does not choke off the opportunities of economic growth. Besides the interim measures implemented to maintain stable financial regimes, it is necessary to step up financial development in those segments where there has hardly been any increase in access to financial and other forms of capital.
The Vicious Circle of Low Innovation
Despite the rapid modernization of most developing and underdeveloped nations, the needs and demand profile of a large proportion of the population that barely manages to eke out a living is hardly represented and accounted for. The result is a dichotomy for most developing nations because their attempt to join the high-tech bandwagon is without sufficient initiatives to mobilize innovation at the grassroots level.
A fundamental reason for this feature is to curb the activity imposed by what can be termed as the vicious circle of low innovation. This is caused by the combination of low risk taking ability, lack of social infrastructure and lack of financial capital.
According to a working paper (2012) by the World Bank about financial inclusion, a sizable portion of the world’s population does not have a formal account in either a bank or financial institution. It estimates that among those adults who live on less than $2 a day, only 23 per cent report having an account at a formal financial institution. Thus measures of financial development that overlook the extent of financial inclusion that exists (or doesn’t) in the developing world would in all likelihood become absent from economic imperatives.
Financing Micro, Small and Medium Sized Enterprise
In order to enable increased financial inclusion and more, microfinance is the most important financial innovation. Its impact on some of poorest communities of the world is remarkable. What differentiates microfinance from other financial innovations is its central goal: to overcome poverty, rather than to maximize profit.
The evolution of microfinance-innovation strategies in accordance with the constraints encountered by society in a particular nation would be a stride towards increasing financial development. Although this is more important for developing nations, it also applies to the developed world, particularly in present times.
For instance, the story of unbridled American entrepreneurship was born out of a context that fostered the entrepreneurial spirit and a milieu in which entrepreneurs thrived. If one delves into the antecedents of big business, one would find that most began as small firms. However, during recent years, small and medium scale businesses have not had a policy context that has either encouraged or supported their expansion.
As most businesses in the world find themselves in a transition from “business-as-usual” to sustainable business, the experience obtained in the microfinance sector would be useful even for those spheres of commerce that may not be described nor classified as social businesses. A more recent term used for all those investments, which are based on principles linked to the achievement of social objectives, is called impact investment—and microfinance represents the earliest instances of such an investment.
Part V: Sustainable Economic Development: Why Technological Advancements Have Failed to Increase our Capacity to Innovate
Part IV: The Building Blocks Of Sustainable Economic Development: Contextualizing Economic Reform
Part III: The Building Blocks Of Sustainable Economic Development
Part II: The 'New Normal': What Will Lead The Next Phase of Globalization?
Part I: Searching for Sustainable Economic Development In Our Rush For Globalization