ABSTRACT
Financial
innovation has been 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.
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