Financial systems provide vital services
Sanderson Abel
Financial innovation can be defined as the act of creating and then popularising new financial instruments.
This implies advances over time in the financial instruments and payment systems used in the lending and borrowing of funds as well as innovations in the payment mechanisms and systems in the economy.
Financial systems provide vital services: they evaluate, screen and allocate capital, monitor the use of that capital, and facilitate transactions and provide risk management tools.
If financial systems provide these services well, capital will flow to the most promising and deserving firms, promoting and sustaining economic growth.
Financial innovation, which is the creation of new securities, markets and institutions, can improve the financial services sector and thereby accelerate economic growth.
These advances include innovations in technology, risk transfer and credit and equity generation.
A number of innovations have taken place over time among them; the development of Automated Teller Machines (ATMs); the expansion of credit card usage; debit cards; money market funds; basic forms of securitisation; venture capital funds and interest rate and currency swaps amongst many others.
Motives of financial innovations
There are a number of motives for financial innovations:
To provide ways of clearing and settling payments to facilitate trade (Credit and debit cards, PayPal, stock exchanges)
To provide mechanisms for the pooling of resources and for the subdividing of shares in various enterprises (Mutual funds, securitisation)
To provide ways to transfer economic resources through time, across borders and among industries (Savings accounts, loans)
To provide ways of managing risk Insurance (many derivatives)
To provide price information to help coordinate decentralised decision-making in various sectors of the economy (Contracting by venture capital firms)
To provide ways of dealing with the incentive problem created when one party to a transaction has information that the other party does not or when one party acts as agent for another
The implementation of an online banking system that allows a user to instantly transfer money from multiple accounts is considered an example of financial innovation.
As seen with the global credit crunch in 2008, which was triggered at least in part by innovative financial products, there will always be a need for careful scrutiny of innovative financial products and their risks.
The very reasons financial firms can be so beneficial to society, their links to the wider economy, leverage and interconnectedness magnify the economic and social effects of failures in innovation risk management.
It is not only the individual institution that will feel the effect of its failure but the wider economy through spillover effects.
Besides the harm financial innovation can bring, research shows financial innovation has more benefits than costs.
Advantages of financial innovation
Financial innovation has been shown to increase the material wellbeing 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, promotes greater efficiency, and facilitates 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 spread 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.
Disadvantages of financial innovation
The World financial crisis of 2007?09 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 subprime mortgages.
Many intermediaries underestimated the risks of new financial products and were compelled to deleverage 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. 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 wellbeing.
Hence, provided that we strengthen prudential regulation to discourage excessive risk taking in the future, innovation can continue to benefit our societies.
Additionally the 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.
- Sanderson Abel is an Economist. He writes in his capacity as Senior Economist for the Bankers Association of Zimbabwe. For your valuable feedback and comments related to this article, he can be contacted on [email protected] or on numbers 04-744686 and 0772463008