Financial Inclusiveness, Now Exclusively for You!

Swaminathan S Anklesaria Aiyar has been writing a regular pop-econ-based column every Sunday in the TOI called 'Swaminomics' for ages now, since well before Freakonomics made pop-econ, umm, popular. This Sunday's article is a bit of clunker though, as he tries to lay some of the blame for the current economic crisis at the feet of financial inclusiveness:

Inclusive finance—giving loans to everybody, including the poor­­­—is desired by politicians in India, and in all democracies. Yet the current US financial crisis shows the perils of taking this goal too far.
The crisis arose from the bursting of a housing bubble. That bubble was created, fundamentally, by government policies and institutions seeking home ownership for all Americans, including low-income ones. Politicians rooted for such inclusive finance. But this “inclusion” extended finance to ever more borrowers with fragile and low incomes, causing disaster. This holds lessons for India.

Opening with that line, he goes off on a general re-telling of what happened, mainly laying the blame on Fannie Mae and Freddie Mac via messed-up tax incentives and securitization. While the facts that he lays out are correct, they do not necessarily lead to the conclusion that financial inclusiveness was at the heart of the mess.

To begin with, while the stated intent may originally have been financial inclusiveness, the tax breaks and government regulation eventually set up incentives that were more attuned to getting the middle classes to borrow more than they could reasonably repay - a tax rebate "on the first $ 100,000 of second mortgages", for example, cannot have been targeted at first- generation immigrants just looking for a place to stay. While financial inclusion may be paid some lip service, most banks would rather lend a large amount to a middle-income family looking to buy a second home than a small amount to a poor family with a poor or non-existent credit history. Middle-class Americans were willing to buy larger homes because loans were cheap, and even with a limited ability to repay, they hoped that if the value of their house kept increasing, they could go in for products like reverse mortgages, that would keep them in the clear. These weren't people who needed to be 'included' into the financial system, rather, they formed the sweet spot of commercial banking activity - not low-income households, but households with a decent inflow of money that flowed into the banks' deposit accounts, and a greater outflow of money, accumulated through the banks' lending products like loans and credit cards.

Securitization, per se, was not the problem - after all, without the ability to raise further financing at reasonable rates through transferring their mortgage portfolio to other financial players, the commercial banks would have been limited in their ability to lend anyway (see asset-liability mismatch). For an explanation of securitization, specifically CDOs, see here.The bigger problem was that not enough people who bought the securities knew clearly what the risks associated with them were. That's partly a failure of the credit rating agencies, whose job it was to assign a level of risk to them, the ability of investment banks to sell products that they themselves had no clue about, and the investors' own greed (for an exposition of the latter two points, you could read Michael Lewis' 'Liar's Poker').

The major problem was insufficient regulatory oversight, as banks could get away with taking more risk than was prudent. An alternative approach to the Fed's would have been the one followed by the Spanish central bank (HT Felix Salmon), taking a more active role in monitoring and proscribing where necessary the activities of the nation's banks that it found fault with. To me, this really is what the role of the government (and/or its agencies) should be - setting up the right checks and balances through the regulatory regime that allows the markets to function as they should. The laisse-faire approach meant that people made up the rules as they went along, relying basically on the brand names and selling skills of Wall Street. Nationalization, on the other hand, produces mixed-up incentives for the nationalized firms.

Aiyar concludes his piece, on somewhat flimsy evidence, by saying that financial inclusiveness can be disastrous on a large-scale, and advocates giving the poor grants instead. This is messed-up thinking on two counts: firstly, financial inclusiveness is not just about giving loans to the poor, it's also about allowing them access to other banking facilities like deposits and insurance, which grants do not necessarily accomplish; secondly, grants are not self-sustaining and rely essentially upon the kindness of the rich.

In the Indian context, I don't think the rich are kind enough, or the kind rich enough, for that to go very far.