Why are financial innovations essential and are they generally essential nowadays? How can financial innovations improve economic welfare of society? Do financial innovations really cause economic crisis and decline? This paper reveals information about these important aspects.
Keywords: Financial innovations, capital markets, financial institution
Financial innovation has been an important part of the financial landscape throughout modern economic history, but still there is a certain lack of information about the importance and influence of financial innovations in global economy. As difficult as it may be to measure the private benefits to innovators, it has proven even more problematic to conclusively model or measure the social welfare benefits of financial innovation, although one can point to specific innovations that appear to enhance welfare.
Financial innovations is a process of creating and then popularizing new financial instruments as well as new financial technologies, institutions and markets. However, this term is too general and includes innovations in the entire financial area, where the resource is any market unit. It is worth mentioning that none of these definitions can depict all complexity of the term “innovation” in the sphere of financial services, where a new product can possess innovational features in the context of its certain functions, marketing, consumer segment or supportive infrastructure.
Financial innovations are frequently divided into product and process innovations, with product innovations exemplified by new derivative contracts, new corporate securities or new forms of pooled investment products, and process improvements typified by new means of distributing securities, processing transactions, or pricing transactions. Nevertheless, it is extremely complicated to differentiate between these two terms, because they are close to each other. The term “innovation” itself includes the process of creating and distribution of new products; in reality these two activities are related to each other, because most of financial innovations are adaptations of prior products.
It is considered that imperfections of financial system and financial market are the causes of financial innovations’ arising and development. These imperfections prevent participants in the economy from efficiently obtaining the functions they need from the financial system. Financial innovations are optimal responses to various basic problems or restrictions that prevent risk shifting. Therefore, there are six main functions of innovations:
- moving funds across time and space
- the pooling of funds
- managing risk
- extracting information to support decision-making
- addressing moral hazard and asymmetric information problems
- facilitating the sale or purchase of goods and services through a payment system
There are two different approaches for explaining why it is essential to observe financial innovations. Some authors support static framework, where no attempt is made to explain the timing of the innovation. Other authors adopt a dynamic framework, where innovations reflect responses to changes in the environment, and the timing of the innovation mirrors this change. Nevertheless, there are six general factors of influence over the financial innovations’ origin and development.
Firstly, financial innovations arise because of the inherently incomplete markets and as a result parties are not able to move funds freely across time and space or to manage risk.
Secondly, financial innovations are essential for diminishing and eliminating inherent agency concerns and information asymmetries between insiders and outsiders. New deals at financial markets are made for accordance between parties or for eminent’ compulsion to reveal information. For example, debt financing stimulates enhancement of discipline among managers when disposal value exceeds its current market value. In this case, managers (insiders) continue their operating activity whereas shareholders (outsiders) prefer liquidation. Enhancement of discipline is carried out in case of debt financing by revealing information for investors, who can trigger the liquidation process.
Thirdly, financial innovations are aimed at lowering transaction and marketing costs. Transaction costs provide a key factor for financial intermediaries who stimulate households facing transaction costs to achieve the optimal consumption-investment level.
Fourthly, financial innovations arise because of tax regulation’s tightening and financial regulation. The list of tax and regulatory induced products would include zero-coupon bonds, Eurodollar Eurobonds, various equity-linked structures used to monetize asset holdings without triggering immediate capital gains taxes, and trust preferred structures.
Fifthly, increasing globalisation, perceptions of risk and volatility of financial markets stimulate financial innovation. With greater globalization, firms, investors and governments are exposed to new risks (exchange rates or political risks), and innovations help them manage these risks. For example, a recent press report announced that the Interamerican Development Bank had created the first-ever instrument that incorporated a currency convertibility and transferability guarantee.
Sixthly, technological shocks stimulate improvement of financial innovations. Advances in information technology support sophisticated pooling schemes that are observed in securitization.
IT and improvements in telecommunications (more recently the Internet) have facilitated a number of innovations, including new methods of underwriting securities (e.g. Open IPO), new methods of assembling portfolios of stocks (folio FN), new markets for securities and new means of executing security transactions.
However, there are some difficulties in measuring the impact of financial innovations on social welfare. There are two opposite points of view and two different conceptions. One of them claims that financial innovation is a kind of engine mechanism for financial system; it improves the performance of real economy and causes the increase in social welfare associated with having new set of choices in comparison with the earlier period. For example, venture capitalists provide a blend of money and expertise to help young firms succeed; credit cards extend credit but also simplify the process of purchasing goods and services. At the same time, financial innovations can be considered as a source of the weakness of economy and a reason of market crashes. One of the demonstrative examples is the impact of portfolio insurance trading on the stock market crash of 1987 (Black Monday). This innovative hedging strategy supposed to manage risk better by protecting investor’s portfolios from unexpected losses with positions in stock-index futures. Any fall in stock prices could be compensated by selling futures bought when stock prices were higher. This strategy actually caused the entire market to collapse from the dynamics of automatic herd-selling of futures. Therefore, even innovations with positive intentions, such as process innovations that reduced the costs can lead to unintended consequences in the economy.
Finally, innovations take an enormous importance in society development. They are one of the three main components of financial mechanism and, interacting with the other two components — investments and competition, they meet the requirements of society, enhance efficiency of financial system and social welfare, and contribute to economic advancement. This approval suits both financial services sector and economics on the whole, so innovations in financial services sector enhance not only the efficiency of the sector, but also the value of equity. Significantly, the majority of contemporary industrial sectors could not exist in the form they are existing now without the function of capital allocation, which financial instruments carry out. That is why innovations in financial services sector have multiplicative effect on overall economy. Nevertheless, in case of ineffective and unproductive implication or control over innovations, the possibility of economic regress is very high.
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