Pros and Cons of Financial Innovation - Essay Example

?Financial s & Market – Financial Innovation Financial innovation hasbeen a topic for debate recently and its pros and cons have been widely discussed. A number of financial experts and economists are of the view that financial innovation should be encouraged as it leads towards new avenues for investment and economic growth, while other experts believe that unmonitored financial innovation is the leading cause behind the financial crises. Financial innovation has been blamed for leading firms and individuals towards high risk investments and in numerous cases, firms and individuals have suffered significant losses due to the unforeseen consequences of such investments. The paper discusses the advantages and disadvantages of the financial innovation. Advantages include; the creation of new securities, creation of new markets and financial institutions and the economic growth. The creation of new securities provides the investors with new avenues to invest in and it injects fresh capital which in turn leads towards increased employment opportunities. The disadvantages include; use of financial innovation for deceptive purposes such as off balance sheet financing and the creation of special purpose vehicles. The paper discusses two cases related to off balance sheet that shed light over the detrimental impacts of financial innovation over the economy as a whole. Financial Institutions & Market – Financial Innovation There has been significant debate regarding the validity of financial innovation. It has been suggested that financial innovation plays a vital role in the economic growth and prosperity and that, resultantly, financial system regulators should resist over-regulation that might create hindrances in the way of innovation. As a counter argument, it has been brought to foreground that certain financial innovations have been blamed for creating enormous economic crises in the recent past. As a result of such financial crises, governments all over the globe are taking extraordinary measures in order to avert more of such crises and they are imposing new financial regulations in this regard. The question that would be discussed in the following paper is whether the potential benefits of the financial system innovation should deter regulators from imposing restrictions on the activities of financial institutions. ADVANTAGES OF FINANCIAL INNOVATION Even though financial innovation has been blamed as the main reason behind financial crises, it has also been said that financial innovation is very important for economic growth. The economic crises that have been said to be due to financial innovation are actually due to the improper use of financial innovation. Innovation, if used properly and constructively, can lead towards growth and prosperity in the economy of a country. Following are some of the benefits of financial innovation: Creation of New Securities Financial innovation is the leading reason behind the creation of new securities. Any creation of securities leads towards new capital which is used for economic growth. By creating of new securities, investors invest in the securities and earn returns while the institutions that create such securities invest the capital for the purpose of economic growth (Kimmel, 2010). The resultant growth creates new job opportunities and adds new revenue to the overall economic system of the country. In this way, financial innovation leads towards new investment and financial growth. Creation of New Markets and Institutions Financial innovation is the reason behind the creation of new markets and financial institutions. For example; the concept of ‘Collective Investment Schemes (CIS)’ came to foreground due to financial innovation and this method is being widely used by investors all around the world to create and invest in investment schemes with different investment portfolios (Boot & Thakor, 1997). The investment schemes are managed by ‘Asset Management Companies’ which have been created specifically for this purpose. The investment schemes are defined by the type of securities they will be allowed to invest in and the investor is given the choice to invest in any scheme. Thus, the returns earned from the investment schemes are distributed among the investors or as they are called in case of CIS, unit holders. Thus, it can be inferred that financial innovation leads towards creation of new financial institutions and new markets. Economic Growth Financial innovation adds to economic growth in a number of ways. By creation of new securities, new capital is introduced into the economic system of the country and this investment results in new employment opportunities and revenue generation. Financial innovation also results in new markets and financial institutions that add to the economic development of the country (Mitchell et al., 2006). Thus, it can be said that financial innovation is one of the factors that help in the economic growth of a country. DISADVANTAGES OF FINANCIAL INNOVATION There is no doubt in the fact that financial innovation has some advantages but its disadvantages seem to be more immense. Experts who do not support financial innovation argue that a good financial system should minimize the extent of risk faced by firms and individuals rather than maximizing it by creating new financial avenues with unclear consequences (Eichengreen, 2010). Financial innovation poses numerous risks to the firms, individuals and economy as a whole. Financial innovation is the reason behind off-balance sheet financing and the creation of ‘special purpose vehicles’. Off-balance sheet financing and use of special purpose vehicles for this purpose have enabled firms to conduct fraudulent financial reporting (Gennaioli et al, 2010). Due to the creation of special purpose vehicles, firms and individuals have suffered significant unforeseen losses (Bernanke, 2009). Some of the cases regarding the use of special purpose vehicles by firms for deceptive purposes have brought the economy to the brink of crises (Haan & Sterk, 2011). Following are the brief details regarding the incidences of deceptive use of special purpose vehicles that caused a stir in the economy: The Enron Case Enron Corporation was the first that brought the use of deceptive off balance sheet transactions to the attention of the general public. The accounting principle that was used by Enron to carry out the off balance sheet financing is ‘mark-to-market’. According to this accounting principle, assets held by an entity, specifically securities, can be held by the entity at their market value. This accounting principle is normally used for securities that are traded in the stock markets but for any other assets, this accounting principle may have detrimental impacts. This principle was used by Enron Corporation in such a manner that the entity would book the profit from its non-current assets such as a power plant even before it starts operating using the discounted market value of the asset. The company used Special Purpose Entities (SPEs) for the purpose of concealing its non-performing assets. Thus, the company showed its financial position to be in a much better form that it actually was. Ultimately the company collapsed and it caused a stir in the Wall Street (Needles, 2010) The Wall Street Meltdown The Wall Street Meltdown of 2008 has also been blamed upon the financial innovation in some ways. The accounting principles that were applied in the real estate investments by the investment banks and lending institutions were the complex principles related to leasing and included innovative financial procedures. The financial institutions used Structured Investment Vehicles (SIVs) for the purpose of keeping the real estate investments off the balance sheet (Pozen, 2009). The value of real estate in the United States peaked in the year 2006 due to the use of complex transactions by the financial institutions and their use of SIVs. Right after reaching its peak in 2006, the real estate market began to collapse in 2007 and due to the significance of the investment by the financial institutions in the real estate market these institutions were unable to remain solvent without the intervention of the government. This caused the Wall Street meltdown in 2008. Before the meltdown, the financial institutions used SIVs to conceal their investments in the real estate and to inflate the real estate value. The system soon collapsed and resulted into a financial crisis. CONCLUSION From the analysis of the advantages and disadvantages of financial innovation, it can be inferred that the disadvantages of financial innovation have led the economy towards the brink of disaster and loosening the regulatory pressure over the financial system may heighten the risk of other crises led by financial innovation. Therefore, it can be concluded that regulators should not ease the regulation of the financial system and the financial innovation should be monitored. REFERENCES Alfaro, L. & Chen, M., 2011. Surviving the Global Financial Crisis. World Trade, 5(11), p.26-31. Bernanke, B.S., 2009. Financial Innovation and Consumer Protection. In Federal Reserve Systems Sixth Biennial Community Affairs Research Conference. Boot, A.W.A. & Thakor, A.V., 1997. Banking scope and financial innovation. Review of Financial Studies, 10(4), p.1099-1131. Available at: http://www.jstor.org/stable/2962340. Eichengreen, B., 2010. The Crisis in Financial Innovation. Depression, 36(January), p.2-7. Gennaioli, N., Shleifer, A. & Vishny, R.W., 2010. Financial Innovation and Financial Fragility. Journal of Economic Issues, 23(3), p.779-793. Available at: http://journals.cambridge.org/abstract_S0022109000012333. Haan, W. D.; Sterk, V. 2011. The Myth of Financial Innovation and the Great Moderation. Economic Journal, June Issue. Kimmel, P. D.; Kieso, D. E.; Weygandt, J. J. (2010) Financial Accounting, Tools for Business Decision Making. 6th Edition. Hoboken, New Jersey: John Wiley Publishers. Mitchell, O.S. et al., 2006. Financial Innovation for an Aging World. National Bureau of Economic Research Working Paper Series, No. 12444. Available at: http://ssrn.com/paper=921041. Needles, B. E. & Powers, M. (2010). Financial Accounting. 11th Edition. Cengage Learning. Pozen, R. C. (2009). Too big to save: how to fix the U.S. financial system. Hoboken, New Jersey: Wiley Publishers. Read More