Go to the root cause

Business Standard, 16 May 2007

Parliament passed an amendment to securities legislation which helps enable "securitisation", a financial engineering technique which will make home loans, car loans, credit cards, etc. cheaper. This legislation is, of course, a valuable step forward. However, the finance minister and the prime minister need to ask deeper questions about the barriers to progress in finance. If every change in financial products or markets requires changing a law or a regulation, it constitutes a license-permit raj, a key impediment to innovation and competition. India needs a legal framework where products, market mechanisms and business processes are not written into financial law. To make an analogy, achieving pollution control does not require writing down details about automobiles into the law.

Organised financial trading is one of the most remarkable features of the market economy. The shares of (say) Infosys are owned by millions of people, who are buyers and sellers in a large, anonymous, liquid market. This process of speculative price discovery also gives good liquidity. Investors are comfortable holding shares of Infosys because they trust the prices coming out of this process of speculative price discovery, and because they know that these shares can be sold at a moments notice.

The loan given to the ordinary homeowner has no such properties. There is no process of speculative price discovery and there is no liquidity. The loan is a bilateral "over the counter" transaction between the homeowner and a bank.

Securitisation is one of the most important innovations in financial engineering, which brings the wonders of speculative price discovery to retail products such as home loans, car loans, credit card receivables, etc. The basic idea is simple. A thousand home loans of Rs.1 million each are parcelled together to make a single bundle worth Rs.1 billion. This is, then, subdivided into a million securities worth Rs.1,000 each. Each security is entitled to a slice of the cashflows coming in from all the thousand home loans.

These securities can now enjoy the benefits of trading, liquidity and speculative price discovery, just like shares of Infosys. The most important impact lies in greater specialisation in the home loan market. UTI Bank may be the best equipped at a customer-facing transaction in Nagpur where a home loan is given out. But a Japanese insurance company is most likely the best equipped to actually fund the home loan at the lowest possible interest rate. When UTI Bank makes a parcel and sells the securities in the market, they landup in the hands of the lowest-cost funding sources, like Japanese insurance companies.

This leads to reduced costs of home loans for households. The role of the bank, then, becomes one of originating and processing loans - and then passing on the job of bulk funding to the securities markets, where mutual funds, pension funds and insurance companies (from all over the world) are best equipped at buying the securitised paper and trading it.

These processes can be made extremely efficient and frictionless thanks to modern information technology. In the US, a home loan that is signed in the morning gets sold on the securitisation market by afternoon. The originating bank holds the home loan on its balance sheet for only a half day.

This paean to securitisation should convince the gentle reader that there are enormous benefits from establishing these linkages from the homeowner in Nagpur, to the origination at a bank, to the securitisation market, to the Japanese insurance company. From 1998 onwards, there has been much discussion about securitisation, and the underlying financial products like credit cards and car loans have gathered speed. There are two pieces of legislation which are related to this field - the NHB Act and the SARFAESI Act. As the above discussion suggests, the heart of the matter is to get to the speculative price discovery and liquidity that is comparable with shares of Infosys. This critical milestone was not possible with these two acts.

With a delay of eight years, we now have the legal foundations required for listing and trading of securitised paper. This does not, yet, get the job done because capital controls come in the way of foreign mutual funds, insurance companies and pension funds buying the paper. RBI will probably come up with a few impediments which will hold back banks and PDs from participating in the market. So there are more hurdles to cross before the promise of securitisation is fulfilled.

Sustained attention and time will be required on the part of the finance minister to resolve these hurdles. On one hand, there is a short-term perspective, where securitisation will not blossom without sustained inputs of energy and time on the part of the finance minister. But equally, from a long term perspective, it is important for the finance minister to ask whether a better policy framework could not be constructed. Finance ministers in the UK or the US do not have to put in a sustained fight to enable one financial innovation like securitisation.

Companies in the real sector do not have to deal with the government in this fashion. When car companies decided to launch a new kind of diesel engine called the CRDI engine, they went ahead and launched it without requiring a multi-year process of interacting with the government. Pioneers in this innovation, such as the Octavia Skoda or the Ford Fiesta, reaped profits as a consequence of being first in this game.

In finance, in contrast, the private sector is in a state of paralysis when it comes to innovation. An innovation in financial product, market mechanism or business processes requires interacting with the government. The government takes many years, and often says no. The profit rate in innovation is low, and this takes away the incentive for financial firms to try to innovate.

The finance minister and the prime minister need to ask fundamental questions about why Indian firms in the real economy are now in a world of fast-paced innovation, where product launches compete with each other in introducing new features and wooing the customer, and why Indian finance (in contrast) is in a state of stasis, immobilised by an all-powerful license-permit raj. The best use of the scarce time and attention of the finance minister and the prime minister lies in attacking the deeper foundations of the license-permit raj, rather than getting engaged with one specific innovation like securitisation.

Back up to Ajay Shah's 2007 media page
Back up to Ajay Shah's home page