What is the impact of financial innovation products on the stability of the global economy
What is the impact of financial innovation products on the stability of the global economy?
Many economists have argued that financial innovations today offer little or no productivity benefit at all and th majority are a largely a matter of rent seeking (Krugman 2009). Others (e.g. Hosking and Jagger 2009) have argued that the impact of financial innovation products such as credit default swaps, derivatives and other contemporary ones on the global economy has been negative with many others blaming them for the 2008 financial crisis (Volcker 2009). The financial crisis of 2008 changed the perception of financial innovation products, derivatives in particular which have been blamed by different analysts as the prime catalyzing force behind the crisis. A high level of financial innovation has been correlated to global growth opportunities and GDP per capita growth in sectors that rely on external financing and innovations. However, such innovation has also been blamed for higher off beat bank fragility, enormous bank profit volatility and lofty bank losses especially during the 2008 crisis (Beck et al 2012).
This essay will thus examine the impact of financial innovation products on the stability of the global economy.
What are financial innovations?
Financial innovation can be defined as the act of developing and then popularizing new financial instruments and new financial technologies, institutions and markets. These include institutional innovations like new types of financial firms, products like derivatives and processes like online banking and phone banking (Mishra & Pradhan 2008).The twist of new financial innovation was a topic that attracted attention among financial experts with the debate about the functionality of these unregulated instruments, with some believing that these technologies drove market perfection by optimizing and scattering the risks, minimizing transactional cost and completing the market, ultimately improving allocative efficiency. Many researchers argued financial innovations would help accelerate the growth of the financial sector and raise the standard of living worldwide (Talwar and Trivedi 2014). But critics saw a market that surpassed risk management within economies, due to undiagnosed counterpart risk market, concentration and awkward incentives (Talwar &Trivedi 2014; Gammon& Wigan 2015).
However, the financial crisis of 2008 changed the perception of these once praised instruments, derivatives in particular, as most researchers blamed them as the prime catalyzing forces behind the crisis that led to the crippling of the financial sector globally (Talwar &Trivedi 2014).
The positive impact of financial innovation products on the global economy
Some researchers contend that financial innovation products contribute to the growth and progress of economies, help them to operate which is the ultimate goal of the financial system (Talwar and Trivedi 2014). According to Beck et al (2012), different theories about the effects of financial innovations have been provided, the traditional-growth view submits that innovation products improve the quality and quantity of banking services, facilitate risk sharing, improves efficiency and completes the market. Beck et al further note that financial innovation has played a key role in reducing the volatility of economic activities in the early parts of the 21st century with products showcasing examples of securities and internet banks among others.
According to Michalopoulos et al (2011) financial innovation products have been the driving force behind financial and economic development over the past centuries. For example, they acted as the emergency for specialized lenders and investment banks that financed the railroad in the 19th century. They also spur the speed of economic growth and the rate of economic convergence, boosting growth by enhancing the efficiency of resource allocation, not simply by boosting capital accumulation. According to theories, economies with financial innovation products develop faster than economies without (Michalopoulos et al 2011).
Financial innovation products associated with risk management have been identified as a major source of growth in the US economy.
According to Talwar and Trivedi (2014), financial innovation has the power to increase the value of individual firms through a complex web of contracts that bind investors, management and other stakeholders together.
Thirdly, financial innovations have also been proved to lead to a strong fall in the interest rates of mortgages.
Fourthly, securitization as a product of financial innovation has been noticed as an extremely innovation for credit markets (Talwar and Trivedi 2014).
The negative impact of financial innovation products on the global economy
According to different researchers and analysts, financial innovation products may have positive goals but have impacted negatively on the economy as witnessed in 2008. Financial innovation products are argued to be among the biggest cause of the 2008 global financial crisis, primarily because they drove credit expansion up. They helped to fuel a boom-bust cycle in the US housing prices by designing securities regarded to be safe but exposing the financial sector to forsaken risks and aiding banks to design products structured to exploit investors less knowledge of financial markets and harnessing regulatory arbitrage probabilities (Beck 2013).
Paul Volcker, former chairman of federal reserve was quoted in 2009 saying that “the ATM has been the only useful innovation in banking for the past 20 years” a statement voiced to assert his disdain for financial innovation products (Shepherd-Baron 2017). He asserted that there was very little evidence that the financial innovations had done anything to boost the economy (Beck 2013). Financial innovation products such as securitization heighten the risk and vulnerability of the economy by encouraging reduced standards of procedures and incompetent evaluation of loans with each party relying irresponsibly on the other to thoroughly investigate loans (borrowers).
Using subprime mortgages as a case in point, investors who bought mortgage backed securities did not keep a keen eye on them, which left financial institutions and rating agencies less versed in understanding their risks, failing to evaluate the complex securities, leading to the 2008 financial crisis (Beck et al 2012 ; Hein et al 2015). Several authors have pinpointed out products like securitization and derivatives as contributing to aggressive risk taking and reduction in lending standards by financial institutions which leads to fragility of the global economy (Beck et al 2012).
A prudent evaluation of financial innovation by researchers also shows many have been introduced to avoid some regulations and to limit client resistance by confusing them through a labyrinth of misinformation. Furthermore, in the past, financial innovation products have been administered in low tax havens resulting in an unregulated system that led to the development of shadow banking systems that were central in causing the 2008 global financial crisis (Talwar and Trivedi 2014).
Financial innovation products also tend to decrease the clarity of the risks being conveyed upon the system thus hoisting the hazard of the ever rocketing financial risks and the persistent decreasing understanding of these uncertainties (Burlamaqui &kregel 2005). They inadvertently help financial institutions avoid provision for losses by shifting investments off the balance sheet to unsuspecting investors. Financial innovation products thus helped change mediators, allowing them to adjust the degree of risks related to their activities without changing their internal structure thus putting the whole system at risk (Talwar &Trivedi 2014).
Financial innovations in a way add unnecessary complexities that make it hard for managers to know what their subordinates are doing, which makes it hard for boards to supervise and makes it even harder for investors to perceive what risks they are taking, leading to an overall fragility of the financial services sector, which negatively impacted the global economy in 2008 (Boot & Arnoud 2011).
It is also worth noting that the financial sector is fragile in countries where banks spend extra on financial innovation, with banks having smaller market shares, faster asset growth and higher shares of non-traditional intermediation activities such as selling securities. This is due to the high profit volatility of banks in countries with higher levels of financial innovation products (Beck 2013).
In conclusion, financial innovation products have both positive and negative impact on the global economy depending on how they are utilized. They encourage banks to take on more risks which helps provide valuable credit and risk diversification services to firms and households, further intensifying capital allocation efficiency and economic growth. On the other hand, innovation products notably increase profit volatility and losses during crises, which renders higher volatility in industries that benefit more from financial innovations. Numerous research shows financial innovations have been accomplishing their main function until much recently when they led to a crush primarily due to some deviant financial schemes and instruments that cast a negative light upon them. Hence all in all, their impact is positive but for financial innovations to have a desired positive effect, it’s vital that they are regulated, otherwise, they can lead to financial instability as the 2008 global financial crisis demonstrated.
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