Essence of financial innovations

Financial innovation is the process of creating and popularising new financial instruments. It reflects advances over time in the financial instruments and payment systems used in the lending and borrowing of funds.

These advances include innovations in technology, risk transfer and credit and equity generation. The creation of new technological advances in the financial has potential to increase amounts of credit to borrowers. In looking at financial innovation over time, it is natural to ask if it is good or bad. Does all innovation make us better off? This is a difficult question, because it is very difficult to measure the benefits or the costs of particular innovations at the time they are conceived.

Since the 1960’s some of the significantly more positive financial innovations that have come across include the following: automated teller machines, massive expansion of credit card usage, debit cards, money market funds, indexed mutual funds, basic forms of securitisation, venture capital funds and interest rate & currency swaps among others.

To what extent have financial innovations played a key role in easing the lives of the public and to what extent are they beneficial to society at large? This seems more of an empirical question requiring detailed research. However, evidence from the financial crisis amply shows that there are consequences associated with financial innovations when the risks are not properly taken into consideration.

Positive innovations

Financial innovation has somewhat increased material well-being of economic players. Positive innovation has helped individuals and businesses to attain their economic goals more efficiently, enlarging their possibilities for mutually advantageous exchanges of goods and services.

Financial innovation by increasing the variety of products available and facilitating intermediation, has promoted savings and channelled these resources to the most productive uses. It has also assisted to widen the availability of credit, help refinance obligations and allow for better allocation of risk, matching the supply of risk instruments to the demand of investors willing to bear it.

Innovation is also at the centre stage of encouraging technological progress when the requirements for information technology generate new technological projects, and induce their funding as in the case of venture capital. Financial innovation lowers the cost of capital, promote greater efficiency, and facilitate the smoothing of consumption and investment decisions with considerable benefits for households and corporations. As the new products contribute to the deepening of financial markets, innovation, in turn, fosters economic development.

Financial innovation may also help to moderate business cycle fluctuations. Innovations such as credit cards and home equity loans allow households to keep their consumption smooth even when their incomes are not. The increased availability of credit to businesses allows them to smooth their spending across short periods when revenues do not cover costs.

The success of any innovation depends on three things. The first is how good the product is to begin with. Some financial products are poorly conceived or designed. Next is the appropriate use of the product: Is the product meant for a particular market or type of risk? And finally, the value of an innovation hinges on the competence of the person implementing it.

Downside of financial innovation

However, the World financial crisis of 2007?2009 is a sharp reminder that financial innovations can bring substantial costs along with the benefits described above. However, sometimes the costs may outweigh any benefits making such financial innovations negative. Many households lost their homes when falling house prices made it impossible to refinance their sub-prime mortgages.

Many intermediaries underestimated the risks of new financial products and were compelled to de-leverage in the crisis. The resulting uncertainty contributed to the seizing up of key markets for liquidity, such as the interbank lending market.

Rapid financial innovation can be a source of systemic risk as evidenced during the financial crisis. When financial products without a track record expand rapidly in a buoyant economic environment, investors tend to underestimate the risks that only occur in periods of economic stress. Separately, innovations that help conceal concentrations of risk can make the financial system more vulnerable to a shock. In both cases, the problem is that investors do not obtain adequate compensation for the risks that they take because they do not understand the risks or because the risks are invisible.

When financial products without a track record expand rapidly in a buoyant economic environment, investors tend to underestimate the risks that only occur in periods of economic stress. Separately, innovations that help conceal concentrations of risk can make the financial system more vulnerable to a shock. In both cases, the problem is that investors do not obtain adequate compensation for the risks that they take because they do not understand the risks or because the risks are invisible.

In conclusion, it should be noted that on balance, financial innovation has had a crucial and positive role in financial modernisation, leading to the improvement of economic well-being. Hence, provided that we strengthen prudential regulation to discourage excessive risk taking in the future, innovation can continue to benefit our societies. It should be further noted that potential problems are likely to increase with the complexity of the instruments, the insufficiency of information conveyed by sellers, and the lack of due diligence on the part of investors.–herald