International Finance and Financial Innovation - Essay Example

FINANCIAL INNOVATION: A CRITICAL REVIEW Introduction In the wide sense, financial innovation refers to the improvements in financial packages, financial products and financial technology that improves and advances the financial sector of a given nation. Financial innovation is an important part of finance around the world and it plays a major role in continuously enhancing and improving the financial terrain of a given nation. This comes with various benefits to most stakeholders. This paper examines the concept of financial innovation and how it is viewed by various authorities and scholars around the world. The paper examines the issue of speed with financial innovations on the markets as well as the role of banks in promoting financial innovation. Finally, the paper examines the potential benefits of financial innovation to stakeholders including consumers, businesses and economies as a whole. Financial Innovation “A financial innovation creates and introduces something new in finance. Generally, the idea of financial innovation involves not only the creation of a new financial concept, but also its production, diffusion and popularization.” (Gorham, Balasubramanian, & Gupta, 2014, p. 797). Financial innovation is about creating something new in finance that improves things for users of financial information and data. Financial innovation is also viewed to be something that involves the development and commercialization of such a financial product to the markets. This includes products, services, production processes and organizations in the financial sector that are new and distinct in various ways and forms. The rational investor seeks to maximize his profits and minimize losses. Hence, there is a natural tendency for people in the investment markets and the financial sector to find ways of improving their returns through the use of better instruments and better products. Therefore, financial innovation comes up as a result of the quest for better products and services in the financial sector. There are many specific reasons why financial innovation occurs. The main and most popular reason for financial innovation is that products on the financial market that are seen to promote profitability are seen in a favorable light rather than products that are seen to be less profitable and prone to attracting higher tax rates. Thus, there is a general tendency for investors to seek better and more improved or enhanced products that helps them to meet their investment and financial ends. The term financial innovation means different things to different people in the financial community. One view asserts that financial innovation is “a payment system advances altering or modifying the role of banks, and financial institutions in general, as intermediaries between suppliers and users of funds.” (Barrons Banking Dictionary, 2006). This definition asserts that financial innovation has to do with the changes in the technological basis that is used by organizations in the financial sector to carry out their practice and activities. It is worthy to note that this definition implies that financial innovation has to do with two main connotations or drivers: 1. The financial/investment products and 2. Technology related to the financial sector This means that the financial innovation is driven by the various arrangements made inherently by financial sector institutions whilst the growth in electronic and technological systems and frameworks changes the terrain of the financial sector. The financial aspects of innovation has to do with how the investment products are designed and how they are presented in a way and manner that enables them to attain better and more competitive statuses in the financial sector. However, technological advancements have to do with the means and system through which production and processing is done in the financial sector. Therefore, financial innovation encompasses these two ideas and concepts and this enables the financial sector to be more effective and efficient in its operations. In some situations, financial innovation relating to changes in financial products and securities is called financial engineering because it means creating new structures in firms that provides financial assets that are better tuned to the pressures of the markets (Hassan & Mahlknecht, 2012). Speed of Innovation in Financial Markets The two main variables responsible for financial innovation are “financial market instability and the rapid developments in information technology” (Lopes, 2012, p. 34). Financial market instability refers to the changes in the financial markets due to regulation changes and changes in demand and the macroeconomic conditions of the state. This includes issues like new government policies and other factors that implies that the conduct and affairs of stakeholders in a country’s economy are to be changed and modified significantly. Financial innovation occurs as a means of making firms in the financial sector more competitive in the industry. This is because the industry has various variables and issues that change over time. Therefore the initiating factors and the responses of players in the financial sector defines the rate at which financial innovation occurs in a given nation or economy. The main drivers of financial innovation include what occurs in a given country’s financial sector. For example, when there was laxity in the US financial markets between 2000 and 2007, many firms in the financial sector came up with various policies to sell more mortgages and provide loans to people. The laxity in the situation caused financial innovation that enabled financial institution to develop products that had lower levels of checks and provided high risk loans to consumers in the United States. When the global financial crisis occurred, and major banks like Worldcom collapsed, there were tighter regulations and players in the US financial markets had to change their products and provide services that provided the best possible opportunities to consumers in the markets within that time. Aside the drivers of financial innovations, the reaction of financial institutions also provide the impetus for defining the speed of innovation on financial markets. In the efficient market hypothesis, it is stated that in a weak market, information is not readily available, hence information does not really promote financial innovation. However, in a strong market, information is readily available and it informs practice. In nations where information is readily used, the rate of financial innovation is meant to be faster and higher than those that are of a lower level of efficiency. Role of Banks in Financial Innovation There are two main angles from which financial innovation can be viewed. The first involves the role of the Central Bank whilst the second is about the role of the commercial banks. This is because the Central Bank and the commercial banks seek to operate against each other on some levels and this causes some degree of conflict which in itself fuels financial innovation in itself. Fundamentally, the Central Bank is used by the governments of nations to carry out the supervision of financial and monetary policy in a given nation or economy. Therefore, in cases of financial pressures and changes, the Central Bank ensures that the polices are carried out and this changes the financial sector of the nation significantly. The financial sector is therefore regulated by the Central Bank and this sets the tone for financial innovation. This is because the limits set by the government including the national budget and national quantitative policies of the nation are to be implemented by the Central Bank. The Central Bank sets up regulations and rules for the operation of all the financial intermediaries in the nation. Hence, the financial intermediaries define their boundaries of how to carry out their activities through the policies of the Central Bank. With this in mind, the financial intermediaries identify the markets that exist in the economy and from there, they can develop the most competitive products and use the most efficient and most effective technological tools to bolster their operations and affairs. The trends of the 2007 Global Financial Crisis caused Central Banks to come together to deal with the issues of the financial sector and it was identified that financial innovation in the global financial sector included: 1. Increased “financialization” of economies (increased lock up of significant percentages of the GDP in financial assets rather than liquid assets); 2. Market-centric structures of the financial economies around the world; 3. Sharp rise in derivative instrument markets; 4. Shadow banking (for example hedge funds etc) 5. Increased globalization of financial markets 6. Sharp rise in the gearing of banks Role of Banks to Financial Innovation Benefits of Financial Innovation to Stakeholders Consumers Business Macroeconomy Conclusion Finanical innovation changes in the financial market Due to technology and financial packages Responses to efficient methods Drivers and responsiveness Read More