Finance is a critical part of every governmental entity as well as business enterprises, and almost all households are clients of one or more financial services, including borrowers, pension beneficiaries, investors, and depositors. Innovation is also a critical factor in every industry and sector of modern economies. It is a crucial business activity that enables them to compete effectually, particularly in the global environment that is getting increasingly competitive. However, for an extended period of time, innovation has been confined to the R&D world in conjunction with the development of products.
As per Davila et al. 1 , innovation is just like any business function as it entails a management process that necessitates the utilization of specific rules, tools, and disciplines. The present growth and profitability do not necessarily guarantee that they will continue into the future, thus the need for innovation to ensure that the cycle continues. Economists concur that financial activities like investing and borrowing are ancient but financial innovations have altered the world from the era when the concept of interest was invented to the current modern equity and debt based mutual funds.
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Financial innovation, as relayed by Ramachandran 2 , is primarily grouped as
New organizational forms, including internet-only banks, novel types of electronic exchange for trades. All these decrease financial risks as well as transaction costs that are entailed in the process.
Novel products including exchange-traded index funds; new services including internet banking, online securities trading, and new production processes like electronic record keeping and credit scoring.
Therefore, financial innovation has three crucial tasks, including, but not limited to 3 :
It ought to address the challenges of missing markets like those required in long-term financing, which is a requirement for the creation of long-lived assets, or for efficacious risk-sharing via the provision of hedging products and insurance.
It ought to deepen the liquidity in existent markets, for instance, in the reduction of disproportionate reliance on a narrow base of depositors for funding.
It can increment economic efficiency on a comprehensive level by levitating the quality and quantity of investment.
Therefore, financial innovations are representative of elements that decrease risks and costs, and also provide an augmented service/product/instrument which satisfies the demands of the participants. Financial innovations typically occur since the participants of the market are continuously in pursuit of novel methods of making higher profits, and whenever monetary authorities restrict or regulate them, new methods and new financial instruments are brought into the market.
However, while the advantages of financial innovations have been documented, its demerits far outweigh its merits, and thus economists and experts have sensitized the need for regulation and supervision of such phenomena. This is because novel financial products and services in the market are often less understood by regulators and thus less supervision and regulation. Most economists concur that among the factors that are at the core of the financial crises is the conceptualization of novel financial products, which is an amalgamation of highly complex, opaque, and ultimately toxic derivatives and securities, inclusive of Collateralized Debt Obligations (CDOs), Credit Default Swaps (CDS), Asset-Backed Commercial Paper (ABCP) and the likes. As per research in the Financial Times, more than half of all of these credit products that were formed from scrutinized bonds have defaulted, and those issued in the last few years are headed towards that process 4 . This adds to the complexities inherent in the financial markets, which often lead to financial crises, according to Omarova 5 , who has often criticized some forms of financial innovations. The author posits that among the most significant causes of the recent financial crisis was the unprecedented level of intricacy and interconnectedness in the contemporary financial markets. This is because complex markets, financial instruments, and institutions create a level of unpredictability, interdependence, and opacity that considerably increment the potential for inefficiencies in the market, as well as systematic failure in unprecedented proportions. Similarly, complexity enables the actors of the private market to engage in extreme financial speculation as well as regulatory and tax arbitrage, thus further incrementing systemic risks and little contribution to the productive growth of the economy.
Among the authors that are actively against the notion of financial innovation is Litain 6 , especially after the 2007 and 2008 financial crisis, which almost brought the US and global economic systems into a delirium. His arguments point towards the fact that vast amounts of innovation in financial markets have had no visible impact on the economy’s productivity. However, before elucidating on how the innovation process in the financial domain has a myriad of deleterious effects, he initially showcases some of the positives. Initially, he argues that there is a mix of bad and good financial innovation and that he had encountered more good ones than bad ones. 7 This showcases that not all cases of financial innovation have adverse impacts on the economy and financial systems, but rather, a select few are the ones causing major nuisances for financial regulators. For instance, some of the innovation merits include the fact that it has enabled parties to pay for each other; it has mobilized the savings of the society, channeled savings towards productive investments, and also allocated financial risks to those that are more willing to bear them. 8 However, besides this, there is substantial evidence that numerous financial innovations are primarily motivated by the facet of evading taxes, circumventing financial regulations, and forging temporary monopolies, which give firms the right to charge excessive fees. 9 This thus calls for whether there should be a creation of ad hoc rules for every new type of financial services and products in order to deter a state of financial instability which Minsky 10 alludes to in his financial instability hypothesis that it is a situation which exhibits inflations and debt deflations which has a significant potential to go out of control.
Allen 11 also notes some of the challenges provided by financial innovations and thus provides some of the recommendations based on other studies, including the conceptualization and implementation of a Financial Product Approval Commission (FDAC) with the discretion to conditionally approve or ban new financial products. Therefore, any transaction that does not entail a financial product that is not approved by FDAC would be deemed unenforceable and void, and any third parties that unknowingly involved themselves in these transactions are entitled to damages and rescission rights. This methodology is superior in contrast to the Posner & Weyl proposal, which prioritizes social utility and thus utilizes this as a basis to make a judgment on whether to approve the novel financial product or service, as a result of innovation. 12
Nevertheless, on a holistic level considering all the elements in a financial system, it would be unsustainable to create ad hoc rules for each new financial innovation because of the complexities involved in creating individual regulations, and thus the best means of regulating and supervising this domain of financial innovation is to create a comprehensive set of standards and rules, that are rigorous and stringent, to which every new financial service or product is subject to, after which they can be approved to be released into the markets. These standards have to consider a multitude of factors, and only those financial products or services that conform to them are approved. This will ensure financial stability and eliminate rogue financial innovations that are designed to leech the economy.
References
Allen, Hilary, ‘A New Philosophy for Financial Stability Regulation,’ [2013], Loyola University.
Crotty, James, and Epstein, Gerald, ‘A Financial Precautionary Principle: New Rules for Financial Product Safety,’ [2009], University of Massachusetts.
Davila Tony, Epstein J. Marc, and Shelton Robert, ‘Making Innovation Work: How to Manage It, Measure It, And Profit from It,’ [2006], Upper Saddle River.
Litan, Robert, ‘In Defense of Much, But Not All, Financial Innovation,’ [2010].
Minsky, Hyman, ‘The Financial Instability Hypothesis,’ [1992], Levy Economics Institute.
Omarova, Suale, ‘License to Deal: Mandatory Approval of Complex Financial Products’, [2012], HeinOnline .
Ramachandran Ramakrishnan, ‘ Financial Innovation and Regulation ,’ [2013], SSRN Electronic Journal.
