r gandhi : finance, credit and markets speech by mr r gandhi, deputy governor of the reserve bank of india, at “ credit summit india 2014 ”, organised by association of international wealth management of india and national institute of securities market ( nism ), mumbai, 26 august 2014. * * * 1. the role of the financial system is to intermediate between lenders and borrowers and provide avenues for saving and help investors find their financing needs. the financial markets impact growth by channeling saving to firms and improving the allocation of capital. moreover, efficient financial markets and institutions tend to lower search and transactions costs in the economy. 2. as the industrialized nations ’ economies grew in the eighteenth, nineteenth and twentieth centuries, their financial systems also grew in depth and breadth. in the 19th century, london achieved its status as the world ’ s leading financial centre, because the financial sector had developed rapidly in order to serve the needs of british industry and british exporters. similar is the case with 20th century new york which played a similar role in relation to the american economy. 3. the relationship between financial development and economic growth is a subject of debate. some economists just do not believe that the finance - growth relationship is important. for instance, robert lucas asserted in 1988 that economists badly over - stress the role of financial factors in economic growth. moreover, nobel laureate joan robertson declared in 1952 that “ where enterprise leads, finance follows ”. according to this view, economic development creates demands for particular types of financial arrangements, and the financial system responds automatically to these demands. 4. the well - known former editor of “ the economist ” walter bagehot expressed this in 1873 as follows “ in england, however,... capital runs as surely and instantly where it is most wanted, and where there is most to be made of it, as water runs to find its level ”. 5. however, it is now increasingly accepted that financial development has a positive effect on growth. financial intermediation can affect economic growth by acting on the saving rate, on the fraction of saving channeled to investment, or on the social marginal productivity of investment. 6. the studies of mckinnon and shaw in early seventies propounded that financial repression depresses growth ; conversely, financial development should raise growth. a positive correlation between growth and indicators of financial development is well documented. a growing body of evidence suggests that financial institutions ( such as banks and insurance companies ) and financial markets ( including stock markets

##tors and entrepreneurs should be largely left alone, or whether public policy authorities should be actively involved in regulating those. 13. innovations bring in positive changes in efficiency, productivity, quality, competitiveness, and market share, among other factors. however, as innovations usually result in paradigm shifts, they are typically disruptive. it takes effort and time to understand them. the associated dangers include untested effects, lack of clarity on long term effects, and can lead to misunderstanding and misusing the innovation. innovations can sometimes be bad per se ; sometimes even good innovations can be misused. 14. the world economic forum opines that financial innovation has been more positive than negative and hence it will be better not to regulate them away by imposing excessively harsh standards or outright bans on new products. the forum suggests that let innovation occur ; but react appropriately and quicker to any flaws that become apparent and therefore the tendency should naturally be to err on the side of caution. 15. an oecd report argues that we should preserve the benefits of innovative activities, while ensuring that new products and services that prove harmful are appropriately contained. indian experience 16. how have we been regulating financial innovations in india? the reserve bank has employed several approaches while examining whether a financial innovation should be regulated. they include : i. to ignore bis central bankers ’ speeches ii. to watch out iii. to regulate passively iv. to regulate actively, and v. to ban 17. what determines the approach? i can answer this in a simple, rule of thumb manner as follows : i. can the innovation cause large scale damage ; then ban it. ii. is the size or magnitude very small ; then ignore it. iii. can informed decision be taken by the consumers ; then caution them. iv. can it be beneficial to many consumers ; passively regulate it with light touch regulation. v. can it be beneficial to many consumers, but consumer protection issues loom over ; then actively regulate it. 18. for example, the prize chits and money circulation schemes have been banned, whereas with regard to the virtual currencies like bitcoins, we cautioned the public about the risks involved in dealing with them. we had a studied stance and we preferred to err on caution based on the simplicity or complexity of the product or service. while we said “ yes ” to micro finance, we said “ no ” to complex derivatives. in some other cases, we looked for risk mitigants and