Financial Innovation as a Basis of Markets - Essay Example

?FINANCIAL INSTITUITION AND MARKETS – FINACIAL INNOVATION This study entails about financial innovations and its effects. Financial innovations have resulted in the development of complex financial techniques and instruments. Technological advancement, globalization, deregulation, etc. can be supposed to be the attributing factors towards the development of financial innovation. Innovations are mainly done to achieve the basic objectives of financial systems like facilitating the required payment instruments, increased savings, reduction in costs, etc. Individuals and business concerns now have a wider range of options with respect to different types of borrowing facilities available to them. However, the recent Global Financial Crisis (GFC) is argued to be the result of this financial innovation. As a result of that most of the monetary policy makers have tightened their regulatory policies and have imposed several restrictions on the financial institutions worldwide. Borrowers have become more sensitive towards interest rates fluctuations in the financial market and the world is experiencing a situation of credit crunch now. Hence it is required to have a reassessment of the monetary policies by different nations in the world with its primary task being financial stabilization. It should also ensure development of financial innovations with more benefits and lesser costs and risks associated with it. Table of Contents Table of Contents 3 1.Introduction 4 2.Role of Innovation in Financial System 4 2.1Technological Impact 4 2.2Globalization 5 2.3Deregulation 5 2.4Europe and its Financial Integration 5 Nature of Financial Innovation 6 Benefits of Financial Innovation 7 Demerits of Financial Innovation 8 Conclusion 8 References 10 1. Introduction Financial innovations can be defined as the improvements in the financial system through the development of new financial techniques and instruments. Technological advancements, deregulation, internationalizations, etc. are some of the key factors which give rise to financial innovations. The various roles played by innovation on the financial system over the years have been discussed in this study. The benefits and costs associated with financial innovation have also been studied. At the same time the impact of Global financial Crisis (GFC) on employment of strict regulatory policies to curb the development of financial innovation techniques has been studied. 2. Role of Innovation in Financial System Financial markets and financial system as a whole have experienced significant changes over the years. Innovations in the financial system have led to the formulation of various financial techniques and instruments. It has paved way to older techniques and instruments used in the financial market. With globalization there has been an increased competition amongst financial intermediaries (Cavanna, 1992, p.1). 2.1 Technological Impact Improvements in technology have a significant effect on the development of innovations in the financial system. Rapid advancement of microelectronics has resulted in the reduction of computer costs and enhancement of computer capabilities. World has become a small place and information can be shared with anyone in no time at all. It has led to financial market integration in the whole world. Share trading has been made easy through improved information systems. Information Technology and financial systems of most of the companies today are integrated and operated globally and adoption of IFRS is getting easier for them (AICPA, 2010, p.2). With advanced technologies available financial institutions are now engaged in financial instruments which are more complex in nature. 2.2 Globalization With globalization companies operate in different parts of the world. It has led to the development of international market which is growing at a rapid pace. Banks and other financial institutions have developed innovative products that could be transacted globally. Globalization has made it possible for a country to attract foreign investors, thereby leading to the development of new investment products (Rousseau & Sylla, 2001, p.3). 2.3 Deregulation Financial globalization and increased competition in the financial market has led to the easing out of restrictions imposed by the financial regulatory bodies of different countries in the world. Deregulation in the financial sector of many countries have resulted in lowering of volatility and risk in foreign economy (Ghironi & Stebunovs, 2007, p.2). Financial institutions have been able to develop means of acquiring foreign funds and lowering its funding costs. 2.4 Europe and its Financial Integration The advent of Euro has given away to many obstacles in the path of free trade in Europe. This can be considered as an effect of financial innovation. Cross border transactions between many countries in Europe was made easy because of this innovation. There has been a significant improvement in the integration of financial system in Europe (European Central Bank, 2011, p.11). Nature of Financial Innovation Financial innovation occurs in the financial market globally when it proves to be profitable in the aspect of achieving the following objectives of any financial system: a. Facilitating proper payment instruments. b. Providing exchange of money between different currencies. c. Providing means of savings through cross border investments. d. Facilitating methods of diversifying and combating risks (Levich, et al., 1988, p.231). The nature and characteristics of any type of financial innovation is based on two aspects primarily. They are: 1. Innovation of new techniques and financial instruments. 2. Separation and combination of individual financial instruments and risks associated with it. Financial innovations can also be characterized as a product innovation or process innovation. It means it is not always necessary that a financial innovation will result in a new financial instrument but it can lead to the development of a new process or technique as well. Financial innovation has led to the evolution of many financial instruments like interest rate and credit default swaps. They were developed because of the increasing concern over hedging financial and business risks in an organization. Options market evolved as a result of the formulation of Black-Scholes Model. Collateralized Debt Obligation (CDO) and flash trading are important developments that took place because of financial innovation. Avoidance of taxes and regulation also led to the various financial innovations like the application of total return swaps that helps in the conversion of dividends received into an income in the form of capital gains. Lower tax rates are charged against capital gains compared to dividend income. Regulation Q developed in United States paved way for several financial innovations like NOW accounts and Eurodollars (Cullison, 1982, p.3). Benefits of Financial Innovation Financial innovations are associated with many incentives. The benefits of financial innovations have been largely confined to the financial community. As for example investors get benefited from interest rate swaps by being able to hedge their risks associated with interest rates. They are influenced to hold securities that are mortgage backed. Business organization gets benefited from swaps by availing the interest rate arbitrage facility (Allen & Gale, 1994, p.5). Financial innovation helps the individuals and business concerns in the economy to share its risks and smoothening of income and expenses incurred by them. Spread betting is a type of financial innovation and is less complex than some of the derivative instruments like options, futures, etc. The income derived from spread betting is tax free and it serves as an incentive towards its use in the financial system. Individuals now have access to wider range of borrowing options because of different financial instruments available due to financial innovation. Financial innovation paved way to the growth of many economies in the world through efficient capital allocation and better management of risks involved (The Economist, 2011). Financial innovations have led to the strengthening of monetary policy of different countries (Kato, 2008). Demerits of Financial Innovation The Global Financial Crisis (GFC) is argued to be the result of financial innovation techniques and instruments employed by different organizations in the world. It has led to the reassessment of the potential benefits of financial innovations by the regulatory bodies across the world. A tighter regulatory policy has been imposed on many financial institutions worldwide. From the point of view of society, financial innovation has brought in less profit and more costs associated with it. Borrowers are now more sensitive towards interest rates fluctuations in the financial market. Financial innovation has led to increased levels of credit and liquidity in the market. It has also brought in more uncertainty in the part of monetary policymakers. Most of the policy makers of different nations are now experiencing credit crunch situation (Kato, 2008). This has led to the tightening of monetary policies by the central banks of many countries worldwide. Conclusion Hence, it can be concluded that financial innovations are key towards the economic development of any nation. Various factors have contributed towards the development of new financial techniques and instruments because of financial innovations. Technological advancement can be considered to be the most important factor towards this development. Individuals and companies now have access to wider range of complex products which can help them to spend less and earn more. However, it has been argued that GFC has led to tightening of regulations by different monetary policymaker across the world. A credit crunch situation prevails all around the globe. There has been a downturn in the economic growth of most of the nations in the world. Hence, the present global economic scenario calls for the stabilization of economies through refinement and reassessment of the monetary policies in order to have financial innovations with more benefits, and lesser costs and risks associated with it. References AICPA. (2010). Financial Systems Considerations in IFRS Conversation Projects. [Pdf]. Available at: http://www.ifrs.com/pdf/10414-378_IFRS_IT_White_Paper_WEB_FINAL.pdf. [Accessed on April 24, 2012]. Allen, F. & Gale, D. (1994). Financial Innovation and Risk Sharing. USA: MIT Press. Cavanna, H. (1992). Financial Innovation. London: Routledge. Cullison, W. E. (1982). Money, the Monetary Base and Nominal GNP. Economic Review. [Pdf]. Available at: http://www.richmondfed.org/publications/research/economic_review/1982/pdf/er680301.pdf. [Accessed on April 24, 2012]. European Central Bank. (2011). Financial Integration in Europe. [Pdf]. Available at: http://www.ecb.int/pub/pdf/other/financialintegrationineurope201105en.pdf. [Accessed on April 24, 2012]. Ghironi, F. & Stebunovs, V. (2007). The Domestic and International Effects of Financial Deregulation. [Pdf]. Available at: http://www.rba.gov.au/publications/workshops/2007/ghironi.pdf. [Accessed on April 24, 2012]. Kato, T. (2008). The Nature and Magnitude of Financial Innovation. International Monetary Fund. [Online]. [Online]. Available at: http://www.imf.org/external/np/speeches/2008/012908.htm. [Accessed on April 24, 2012]. Levich, R. M. et al. (1988). Financial Innovations in International Financial Markets. NBER. [Pdf]. Available at: http://www.nber.org/chapters/c6222.pdf. [Accessed on April 24, 2012]. Rousseau, P. L. & Sylla, R. (2001). Financial Systems, Economic Growth, and Globalization. NBER. [Pdf]. Available at: http://www.nber.org/papers/w8323.pdf. [Accessed on April 24, 2012]. The Economist. (2011). Financial Innovation. [Online]. Available at: http://www.economist.com/debate/overview/166. [Accessed on April 24, 2012]. Read More