Financial Innovation

Any innovation arises out of a visible need or to improve current standards that can vary from cost reduction to ease of use to make money. Thus by birth, an innovation is not good or bad. It is decided by how it is used in future. It can die unnoticed, serve human mankind or lead to destruction.

Imagine a life without money that in financial terms is known as currency. How will you buy stuff from market?  It is impossible to think. Financial Innovation dates back to as early as in 7^th Century B.C. with the introduction of coins in the Greek state of Lybia which today in the form of currency we use in our daily lives. Thus, if it were not for that financial innovation we would still be using the barter system.

The last two decades have seen a sudden increase in financial innovation with one of the reasons for it being the more use of Information Technology in the financial world. Some of the beneficial  financial innovations  had been zero coupon bonds, puttable bonds , Treasury STRIPS etc. With growth of derivatives and other financial tools, the circulation of money in market has increased exponentially and contributed to the development of economies. When junk bonds were introduced in 1980s they were ridiculed by many but today they are lifeline of many start ups and companies who do not get access to capital otherwise. It has lowered the cost of borrowing for firms and helped in building the entrepreneurial culture. Thus, financial innovation is very much important for economic growth and is a lifeline for any progressive system.

Recent recession has aggravated the debate on whether financial innovation is an evil. However, at the same time the recession has put forward a very important question on what should be done to ensure that these kinds of events does not happen again in future. Clearly stopping financial innovation is not a solution. But some measures need to be taken to prevent this to happen again. Clearly, there is a need to scrutinize the financial products more closely in future. Regulations need to be strengthened. Recession also points out to the fact that the policy environment needs an overhaul. It is easy to declare Financial Innovation as the evil behind the crisis but it is actually a result of a clear policy failure. The risk taking mistakes by the financial managers in the subprime mortgage market were encouraged by the weak policy environment that allowed them to underestimate the risk involved. Credit was made available very easily thus again pointing towards failed policy environment. Rating agencies failed to guide the customers properly. Hence, pointing fingers at financial innovation is running away from the root cause of the problem. In addition, any financial innovation like other innovations is seen by the world with same skepticism and distrust. Thus, just blaming the recession which was more a cause of human greed to the beautiful innovation of CDS is definitely unjustified. The actual idea behind subprime mortgage was to help people who dreamed of owning a home to realize their dream.

Currently the regulatory reforms fail to match the dynamism of the financial sector .The need of the hour is to understand that the economic growth, financial innovation and regulations are linked. Financial innovation and regulations have to keep evolving with time to sustain economic growth. Instead of regulations curbing financial innovation, the regulations should ensure that the innovation does not lead to destruction and actually does what it was intended to do.

One cannot deny that the improper use of financial innovation can lead to harmful consequences. But the same is true for any innovation. But the important point is that the positives of financial innovation do outweigh the negatives and at same time negatives can be controlled with better regulations and policy environment. Thus, stereotyping it as an Evil is completely unjustified and inappropriate.