Financial System Innovation - Essay Example

Finance and Accounting The financial system of innovation brought many potential benefits that financial analysts considered them as a subject that required them to strive and develop common, principle-based policies that could clearly define financial objectives. They resolved on whether to deter regulators from imposing restrictions on activities of financial institutions. It is of great importance to remember that without financial innovation it is inconvenient for companies and households to manage risks efficiently. After assessing things like stock market capitalization, employment, profits, contribution to Gross Domestic Product and the likes, it is clear that the financial system expanded by a big margin since 1990. For instance, by 1989 the global financial assets were about 50 trillion but increased to about 200 trillion by the end of 2007 (Anderloni, 2009:23). Generally, analysts describe financial system innovation as the key to ending the financial crisis and woes that are facing the world’s economy. This is because; assessments carried out to establish how the system has been working reveal that it is through innovation of new financial tools that can put to an end the world’s common complex financial crisis. As illustrated by progress of financial innovations, the way people handled financial matters twenty years ago is different today. Advancements and innovations regarding financial technology transformed apparently due to need for better financial management brought about by time and technology. Globally, people are able to face and overcome challenges regarding finances as a result of financial innovative systems. However, before regulators start making decisions on how to regulate, if they should, activities of financial institutions, it is vital that they consider the consequences of their actions. Since it was through financial system innovation that global financial assets rose from about 50 trillion to about 200 trillion globally within a period of only eight years, these benefits should deter regulators from imposing restrictions on activities carried out by financial institutions. Furthermore, it is within the same period when financial depth increased from 200 percent of world Gross Domestic Product to 400 percent (Zeng, 2011:133). These remarkable financial systems of innovation played an important in transforming the financial sector globally. While on the verge of prominently addressing challenges and risks that the financial system innovation may pose to the general financial sector, there is also the need to view the immense economic gains and benefits that flows from a healthy financial instrument or institution. With the increasing jiggle or sophistication and size, depth wise, of financial markets, that promotes economic development or growth it is crucial to allocate capital in places where it can be highly productive. At the same time, dispersion of perils or risks more widely and broadly all over the financial system has up to this far raised the system’s resilience and the economies shocks (Welfens, 2011:67). Therefore, it is advisable for regulators to be cautious when seeking to implement regulations of financial innovations as they also seek to address risks accompanying the innovation. Financial system innovations have come with lots of potential benefits that financial regulators find them in need of monitoring. Nevertheless, while developing a framework for regulating these benefits brought about by the financial system innovation it is essential to have a clear thinking. The regulators should be explicit on how to regulate public policies, if any, and how fresh innovations or developments threaten or undermine those objectives. In addition, regulator should also consider the roles played by the market in controlling risks that pertain to public objectives since market discipline can be prove to be a key element in a well-functioning regulatory project. Therefore, as a test of consistency, all regulations should be able to fulfill their set objectives across both financial system of innovations and financial institutions. However, if the financial system poses a threat to the public policies it is recommendable for regulators to impose restrictions to the relevant financial institutions. Regulators should be hugely attentive when imposing restrictions on activities of financial institutions as their actions may result to enormous market frictions. Potential benefits reached through systematic financial innovation deliver immense economic growth or loss if not well regulated. For example, hedge funds and derivatives are crucial items in the financial sector (Acharya & Richardson, 2009:233). Therefore, it is of great concern for regulators to consider what these two items bring into the market. Increased freedom of taking actions is the key factor as to why regulation is highly recommendable when dealing with hedge funds and derivatives. Thus, if these two items pose a threat to market retrogression, regulators should impose restrictions on activities of the financial institutions involved Potential benefits realized from financial system innovations are tasking financial regulators with hard chores. The complexity generated by new financial benefits and trading strategies is a potential concern for policing. For example, financial analysts depict that not all credit derivatives are complex. Again, not all financial institutions that are complex link to credit risks. People see single-name credit default swaps as well as credit default swap-indexes relatively simple financial instruments. On the other side, they perceive exotic interest rate derivatives from another class complex. The case is, in contrast the former might be more ambiguous compared to the latter. Additionally, some financial system innovations may not necessarily be more complex compared to some other structured securities (Lundvall, 2010:171). Therefore, regulators should resolve to use potential benefits of innovative systems when imposing restrictions on activities of financial institutions since a consistent regulatory scheme requires monitoring. This fact seconds the essential characteristics of financial institutions and does not pose risks for policy objectives. Globally, financial innovative systems created financial stability, protection of investors, and market integrity through public policy objectives (World Bank Publications, 2012:46). Because of three public policy objectives, that remained unaltered for decades even after financial innovations accelerated, they continue to provide a basis for international cooperation worldwide. From a financial institution point of view, the value for ensuring financial stability remains critical. For regulators, they cannot prevent financial shocks, but on the brighter side, they can at least mitigate financial effects by making sure that all innovated systems remain fundamentally sound and effective. As illustrated, if financial innovations of particular financial institutions can attain potential benefits like creating global financial stability and market integrity, then regulators should not impose restrictions on activities of such financial activities. It will be necessary for regulators to regulate activities of financial institutions by imposing restrictions if the financial innovative system creates challenges to policymakers. This might take place in cases where activities of a particular financial institution do not take into account measures of managing risks. This is because, financial stability depends on absolute and adequate risk management and how those participating in the market manage them. Financial innovation systems, even if with potential benefits, that might make large financial institutions or adequate number of smaller financial instruments fail to manage their risks, makes regulators conform to deter such activities by those institutions by imposing restrictions. This is due to; failure to deter activities that pose such threats leads to threatened and obscured sovereignty of financial institutions, their activities, and the well-being of the whole system. On the other hand, some potential benefits born from financial innovative systems should deter regulators from imposing restrictions to financial activities if the financial innovations bring potential benefits like making risk management simpler and easier. With current financial innovative systems, financiers can now slice and dice risks and easily move them off the balance sheet. Due to pressing need for better risk management and risk sharing strategy, financial innovation is now the driving force behind activities of financial institutions. Moreover, market strategies that are in line with financial innovative systems portray regulator’s need to keep off innovations that are contributing to easier risk management strategies. Thus, financial institution’s activities need no restrictions while working with such innovations. Financial innovation is clearly helping consumers as they now can access many expensive products. Financial innovative system drove down costs making it possible for consumers to own houses through conventional loans that are easily accessible. Conventional mortgage loan interest fell down from roughly 2.5 percent of balance loan to 0.5 percent making it manageable for consumers (Allen, 2012:21). In this case, financial innovative systems bear potential benefits to both customers and financial institutions, as customers are able to own houses at a relatively cheap cost and for financial institutions, the number of clients increased. In such a scenario, these benefits make if unnecessary for regulator to impose restrictions on activities of financial institutions. As time surpasses, financial institutions continue to witness innovations with potential benefits. Innovations allowed financial institutions to create brokers who act as their intermediaries. This expanded the service of mortgage pool in a way that led to devolved lending volume and specialization. As a result, the activities of financial institutions resolved in bringing potential benefits to their clients. In fact, with the latest system of financial innovations, a customer can just walk into a bank, apply for a loan, and have it processed within the shortest time possible unlike old days where it would take quite sometime. The financial innovation that brought this calculus time span for financial breakthrough was indeed a potential benefit to financial institutions and their prospective clients. Therefore, this positive side of this financial innovation should deter regulators from imposing restrictions to this activity of financial institutions. In cases where potential benefits of financial innovation pose possible economic destruction, regulators must impose restrictions on financial institutions. For example, financial innovations that tend to benefit only a number of financial instruments without regarding the broader economy need restrictions. This occurs due to some modern finance sophistication that eventually increases severity and frequency of crises. In this scenario, the insiders behind the financial innovative system benefit handsomely while hurts everyone else. Therefore, when keenly defined using societal point of view, it brings nothing else but many costs and scant gains. Hence, regulators have the right to respond to potential benefits of systematic financial innovations by imposing restrictions on activities of all the financial institutions or instruments involved. Preferably, regulators should not impose restrictions on activities of financial institutions when these institution’s financial innovative systems contribute to potential benefits such as the coming up with the right kind of innovations that can help the financial sector meet its core purpose. Financial innovations that boost the activities of financial institutions to fulfill their functions much better, at a lower cost, and within the fixed time line, should deter regulators from attaching strings on financial institutions. Furthermore, if the same financial discoveries foster growth of economy and societal well-being, restricting such potential benefits is highly not recommendable. The invention of structured products brought with it some potential benefits. They led to competition them and hedge funds in the asset classes that resolved to meet the aspirations of investors. At the same time, structured products protect the downside risk of capital of the investors. Under structured products category, other minimum products that fit into this group include Constant proportion Portfolio Insurance. Surprisingly, some financial investors tend to make promises to business investors to invest in a passive product. In short, in case something goes wrong they do not receive skills of hedge funds manager. Regulators should be on high alert to impose restrictions on activities of any financial institution taking in benefiting from sell of these complex structured products without explaining their complexity or risks to potential clients. The potential benefits brought by financial innovation of private equity might make financial regulators restrict financial institution’s activities because some people might mistake private equity with an innovation since they may fail to notice the long it has been in the market even though Trade Union movement in Europe views it as a newly arrived product. Private equity is a indeed a booming product again due to the low global capital cost that is making it cheaper for borrowing in view of buying currently. As a result of various activities carried out by financial institutions leading to low cost of borrowing, financial innovations benefits are helping to carry trade resulting in spread inverted yield curves and narrow cooperate interest rates. Potential benefits realized from inventing private equity can deter regulators from restricting activities of financial institutions or instruments. Practical potential benefits of financial innovative system are the incentives. These may give regulators a hard time when deciding on measures necessary for effective control. The problem associated with incentives is incomplete information. According to world vision of complete and efficient market, risks depend on complete information. However, things become difficult when financial institutions and the relevant parties treat risk as exogenous. Furthermore, when there is incomplete information from financial institutions, uncertainty actions make incentives facing individual agents become very vital hence can lead to endogenous creation of risks within the financial innovation system (Burton, & Brown, 2009:211). In addition, financial activities of institutions may not screen potential borrowers adequately if those institutions find the loan originators not having sufficient capital at stake. It is hence advisable regulators to use potential benefits as a measure of imposing restrictions on activities of financial institutions. Credit default swaps is a potential benefit of financial innovation and investors can use them to separate return on a corporate bond into compensation for default risk and then earn the compensation on a free security (Welfens, 2011:451). To add on that, an investor in need of making internal temporally transfer and does not intend to incur any credit risk, he or she could buy a bond and purchase corporate credit default risk protection. This means that the investor retains exposure to the cash flow on the free risk component of the underlying instrument. This leads to expanded volume of low risk investment portfolio while creating a market for those willing to trade default risks that allows cleaner pricing of dimensional risks. Consequently, benefits obtained from systematic financial innovation of this product could deter regulators from imposing restrictions on activities of financial instruments or institutions. The potential benefits of financial innovations brought about by activities of financial institutions are immense. Financial institutions are now able to provide their clientele with a product known as the collateralized debt obligations. This enables investors to take a position on corporate credit risk through purchasing a securitized product such as the collateralized obligation whereof, it creates a pool of assets like corporate bonds. This in turn enables investors to take positions on the default losses scale within the underlying asset pool. Potential benefits of financial innovative systems are engineering the decomposition of corporate credit risk into divergent sub components and reversing these sub components into new potential benefits of financial innovations containing different risk characteristics (Saunders & Cornett, 2011:92). Thus, such kind of financial innovative systems should deter regulators from imposing restrictions on activities of financial institutions. According to financial analysts, it is in very few situations that people can talk of new products. Nevertheless, regarding the benefits of the product born by financial innovative systems makes people find the real new product in their perspective with relativity to the economy size that it can serve. This perceives that, agreements of repurchasing are far apart from being a phenomenon of novels. Recently, magnitude of repurchasing agreements within United States’ financial system was not precedential totaling up to less than half of the intra-sect oral borrowing but matched by enormous rise in volume of trading relative to underlying real activities. In relation to this, regulators should put considerable notion when imposing restrictions on activities of financial institutions. In conclusion, generally, financial innovations are currently fighting the financial crisis the world is undergoing. Potential benefits attained from financial innovative systems are of great importance to our economy. Practically, even though these benefits require regulation, the aim of regulation resolve to maintain and preserve those potential benefits and at the same time achieving the necessary public policy objectives that would include market integrity, investor protection, and financial stability. Although systematic financial innovations facilitate those objectives, devising the appropriate regulatory measures to activities of financial institutions regulators should seek to provide principle-based approach that upholds clarity and presents a safe environment for all characters present in the financial market. Bibliography Acharya, V. & Richardson, M., 2009. Restoring financial stability: how to repair a failed system. New Jersey: John Wiley and Sons. Allen, F., et. al., 2012. Fixing the Housing Market: Financial Innovations for the Future. New Jersey: Pearson Prentice Hall. Anderloni, L., et. al 2009. Financial innovation in retail and corporate banking. Cheltenham: Edward Elgar Publishing. Burton, M. & Brown, B., 2009. The Financial System and the Economy: Principles of Money and Banking. New York: M.E. Sharpe. Lundvall, B., 2010. National Systems of Innovation: Toward a Theory of Innovation and Interactive Learning. London: Anthem Press. Saunders, A & Cornett, M 2011. Financial institutions management: a risk management approach. New York: McGraw-Hill Irwin. Welfens, P., 2011. Financial Market Integration and Growth: Structural Change and Economic Dynamics in the European Union. New York: Springer. Welfens, P., 2011. Innovations in Macroeconomics. New York: Springer. World Bank Publications, 2012. Agricultural Innovation Systems: An Investment Sourcebook. Washington: World Bank Publications. Zeng, D., 2011. Applied Informatics and Communication, Part 2: International Conference, ICAIC 2011, Xi'an, China, August 20-21, 2011, Proceedings, Part 2. New York: Springer. Read More