Financial Innovation - Essay Example

Financial Innovation Many economists have been skeptic to financial innovation arguing that it has unprecedented effects to the taxpayers. Various economic arguments have proved the need to institute economic policies to guide the financial innovation. Evidence adduced in this paper illustrates various instances of financial innovations that exempted regulation. The consequence has been economic crisis. Introduction The performance of the financial sector is crucial to the economy of the country. Innovation in the financial sector can contribute to the growth or destruction of the economy. The economic growth over the past few centuries demonstrate that effective approach to financial innovation could create prosperity of the nations. However, the issue of financial innovation has drawn criticism from some economists who believe that frequent economic crises experienced in the recent years are due to financial innovation. This paper seeks to debate the question should the potential benefits of financial system innovation deter regulators from imposing restrictions on the activities of financial institutions. Financial regulations serve to regulate the activities of financial institutions against plunging the financial market into chaos. For instance, the Federal Reserve requirement dictates the base lending rate that a financial institution should observe when lending in the public. However, it is evident through the recent financial crisis that financial innovation that led to deregulation exposed the economy to erosion. Economists have observed that banks and other financial institutions in the money market are in constant competition (Anderloni 56). This competition influences the practices that a financial institution would employ in conducting its business. Thus, financial institution practices must observe a given limit in innovation. For instance, studies on the cause of great depression have indicated that financial innovation practices subjected the economy to high-risk behavior whose consequence was the great depression (Calomiris 6). Critics to financial innovation have argued that benefits of financial innovation have failed to yield the anticipated growth because of the risk factors, which the innovation creates in the financial sector (Meessen 199). Most financial innovation leads to excessive risk taking or failure of the financial institutions to predict the financial behavior in the future. For instance, speculation by financial institutions prior to the 2007 US economic crisis led to high risk lending by most financial institutions leading to the collapse of many institutions because of credit defaults. Innovation practices are beneficial to the growth of the economy when the operations are within some control. The Federal Reserve Act 1913 sought to cushion banks from risking foreclosure during financial constraints (Anderloni 156). The idea behind the Federal Reserve is to promote practices that promote the interest of the society. The Commission Inquiry on Financial Crisis report indicated that lack of transparent practice among banks led to unscrupulous lending in the subprime mortgage leading to the financial crisis (A.C.S.1). Lending laws set some base lending which protect the interest of the investors. For instance, the Volcker Rule influenced the banking practices by influencing the operation of the financial institutions within a ring fence. The rule defined the operation of the banks within national and foreign category. The category of these financial institutions enables a given banks within the ring fence to operate a particular financial activities (Calomiris 3). On the contrary, failure to categorize the banks within particular operating spheres exposed the public to risks because large financial institutions collapsed with investment of the majority of the public. Financial innovation should be subject to regulation because some of the innovation practices or proposals fail to reflect the real effects that they would create in the financial market (Schmid 4). For instance, financial innovation in India led to reduction in cost of transactions and increased capital market efficiency. Critics believe that India posted this impressive result because of the existing laws, which defined the boundary of the innovation (A.C.S 1). Tragically, the financial innovation in the western countries was a reverse of the Indian scenario. The innovation in the financial market did not restrict banking practices between the national banks and the foreign banks. The banks did not portray a clear picture of assets, which they had against the debts they incurred. Proponents for financial innovation argue that financial innovation did not start in 20th or 21st century, but in 19th century (Lepinay 123). It opened avenues for potential profit railroad in the 19th century. However, the innovation did not prove smooth for the financiers. The characteristics of the novelty in the whole investment dissuaded capital sources of that time, banks, and wealthy investors. Financial innovation led to the success of this potential project. The current benefits of the project are viable in the society. It is evident that financial innovation created a crucial ingredient for the potential project, it is important to acknowledge the laws and regulations that cushion the whole process. Housing bubble in 2006 was a result of unregulated financial innovation in the mortgage industry (A.C.S 1). The financial innovation rolled out by Freddie Mac and Fannie Mae was critical to Americans. The purpose served by Freddie Mac and Fannie Mae during the financial crisis has proved to economists that financial innovation cannot yield effective and sustainable result in an environment without financial regulation. Reports about the cause of the recent financial recession implicated Freddie Mac and Fannie Mae (A.C.S 1). It indicated that the lending practices of these firms violated the Federal Reserve requirements because they did not care to access the potential damage of the risk incurred. The housing bubble in 2006 and 2007 was due to unregulated financial innovation. Paul Volcker argued in his famous Volcker rule that regulating the activities of the financial institutions is essential because it steers the intentions towards a desired result (Lepinay 152). The collapse of AIG and Lehman Brothers is evidence that financial innovation may prove dangerous when rules do not apply. Prior to the financial crisis, the above institutions posted impressive result in the capital market. However, the good result did not last long, these institutions engaged in speculative practices, which were risky. Critics argue that the financial innovation that led to the increase in borrowing power did not evaluate the outcome before rolling the system (Tufano 2). It is evident credit defaults swaps were useful to institutions like A.I.G to make cheap money (Tufano 5). The banking requirements dictate a given value against collateral that borrows should present to the financial institutions. At the same time, financial institutions must maintain a given sum of assets before practicing as a financial institution. On the contrary, Federal Reserve did not regulate the practices of many financial institutions because of the deregulation act 2005. In conclusion, financial innovation is essential in the financial market because of the needs, which arises in the economy. However, the success of these financial innovations depends on sound regulations, which dictate the innovations. Various examples illustrated instances of unsustainable financial innovations that have exposed the world to economic recession. Financial innovation observed during great depression and the resent 2007 to 2012 US economic crisis is evidence that financial innovation must operate within some restriction. In both cases, taxpayer’s became prey to the poor financial schemes that benefitted a few leaving the whole world grappling in the aftermath of the unsecured financial practices. Work cited Calomiris, W. Charles. Financial Innovation Regulation and Reform. Web 15 May 2012 from http://www.cato.org/pubs/journal/cj29n1/cj29n1-7.pdf Eatwell, John & Milgate, Murray. The Fall and Rise of Keynesian Economics. Oxford: Oxford University Press. 2011. Print. Lepinay, A. Vincent. Codes of Finance: Engineering Derivatives in a Global Bank. Kentucky: Princeton University Press. 2011. Print. Anderloni, Luisa. et.al. Financial Innovation in Retail and Corporate Banking. London: Edward Elgar Publishing. 2009. Print. Schmid, Volker. Financial Innovation - with a Particular View on the Role of Banks. Munich: GRIN Verlag. 2011. Print. Meessen, M. Karl. et.al. Economic Law as an Economic Good: Its Rule Function and Its Tool Function in the Competition of Systems. New York: Walter de Gruyter. 2009. Print. Tufano, Peter. Financial Innovation. Web 15 May 2012 http://www.econ.sdu.edu.cn/jrtzx/uploadfile/pdf/books/handbook/10.pdf A.C.S. The FDA approach to regulation. Web 15 May 2012 http://www.economist.com/blogs/freeexchange/2012/04/financial-innovation Read More