The Financial System Innovation - Essay Example

?Should the potential benefits of financial system innovation deter regulators from imposing restrictions on the activities of financial s? Table of Contents Table of Contents 2 Introduction 3 Financial innovation: bane or boon 3 Necessity of regulation 7 Regulatory measures and their potential impact 8 Conclusion 11 Bibliography 14 Introduction The introduction of sophisticated derivative contracts, new types of “pooled investment products” and new forms of corporate securities exemplifies the financial innovation achieved in modern financial markets. Over the years, there has been a sharp rise in the number of securities at the disposal of investors as well as a fall in the costs associated with their trading and holding. The process of financial innovation has been viewed to be beneficial even by the economists due to two main reasons. Firstly, it spurs economic growth by facilitating the easy flow of funds from the agents who have less or limited productive projects to agents with higher productive avenues. Secondly, the level of risk taken by an investor is reduced on account of a broader availability of assets resulting in greater diversification benefits and risk sharing. However, the above views have come under tremendous criticism with the predication that financial innovation reduces the risk exposure of the investors. The financial innovation was essentially introduced from a positive perspective but it has been seen that these innovations had a negative impact on the overall economy. Though the main purpose of this innovation was to aid the growing external debt market in U.S., it is now blamed to be the pivotal cause of the recent credit turmoil. To avoid such recurrences in the future, the regulatory bodies need to exercise a greater control over the financial markets. (Piazza, “Financial Innovation and Risk, The Role of Information”). Financial innovation: bane or boon Innovation is a ‘double-edged sword’. Internet is considered to be a ‘boon’ for the overall society but it is also the reason for various internet frauds and indulgence in time-wasting activities. The financial innovation is also subject to this rule. Though it has contributed positively, it is also considered to be one of the main reasons behind the recent damage. This blend of good and bad means the views on financial innovation is likely to be very subjective. As in the case of automobile inventions, while some view it as a gain for the economy and society; there are others, though very few in number, who believe that pollution and accidental deaths arising from this invention outweigh the societal and economic benefits. According to analysts, ‘financial innovation’ caused the recent financial crisis with the extent of culpability ranging from secondary to extreme. According to some, financial innovation has led to some very effective inventions such as the ATM machine whereas the other financial inventions like Structured Investment Vehicles (SIV’s) are a bane. The list of positive innovations includes Automated Teller Machine (ATM), debit cards, money market funds, exchanged traded funds, indexed mutual funds, currency and interest rate swaps (The Brookings Institution, “The Pros and Cons of Financial Innovation”). The use of debit cards has enhanced the attractiveness of accounts as people no longer have to stand in queues to withdraw money. The introduction of financial swaps has empowered the businesses to hedge against any unforeseen circumstances. So, if a business with a huge export base is wary of depreciation of the receivables then it can take a suitable position in the currency swap. By this way, the value of its receivables remains intact. Similarly, a prospective borrower afraid of rise in interest rates, can buy forward rate agreements (FRAs) that will safeguard his position in the event of any unfavorable movement in interest rates. Financial innovation has empowered the domestic companies to raise the necessary funds or invest surpluses in the foreign capital markets. The business technology facilitates an active review of the economic information in context of the international markets thereby enabling the companies to make use of the positive financial information to their own advantage. For instance, a company can exploit any favorable movements in the exchange rates and enhance their capital outlay by acquiring funds from the overseas markets (Walden University, “New Foreign Monetary Strategy”). The negativities associated with the financial innovation are mainly driven by the damages caused during the recent credit fiasco. Some of the derivative products like Collaterized Debt Obligations (CDOs), Credit Default Swaps (CDSs) and SIVs have been randomly abused. Prior to the crisis period, these credit derivatives were unanimously welcomed by the policy makers. The major support lay in the efficient risk allocation offered by the sophisticated products. For instance, a bank can enter into a credit protection by taking position in a CDS owing to which the credit risk gets transferred to some other party, say an insurance company. Besides offering protection against credit risk on a large loan, the credit derivatives help in insuring risks associated with counterparty default. For instance, a firm that initiates a contract with a third party can safeguard the risks associated with a third party default by using CDS. Therefore, CDS facilitates improved efficiency in the markets with high counterparty risks. Other than risk mitigation, the other benefits associated with credit derivatives lays with respect to improved accessibility to financial resources for the firms and households. Suppose a bank’s risk bearing capacity is limited then the transfer of default or any form of credit risk to another party enables the bank to take upon new risk such as granting new loans. This facilitates better credit availability for the firms and households as well. Besides hedging the credit derivatives, it can also be used for speculative gains. For instance, the participants in various markets can buy or sell CDS to make gains from their views regarding a firm’s creditworthiness. The information relating to the credit positioning of a firm can be availed in the related markets. As a result, the credit derivatives markets offer firm specific information that complement or is even superior to the information given by the rating agencies. However, the recent credit crisis has altered the peoples’ perception about the potential benefits of credit derivative products. It is believed that the credit derivatives, instead of contributing to the stability of the financial system, propagated the crisis from U.S. to other global destinations. While the credit derivatives facilitated easy credit at affordable rates, most of the additional credits need not have been disbursed in the first place. Instead of increasing information efficiency, the opaque transaction in the CDS markets led to a disruption in the inter-bank markets. The aim of these structured derivative products was to reduce systemic risk but it instead aggravated the systemic risk. An important problem was that the sophisticated instruments failed to shift the risks outside the banking system as a large chunk of it remained within the sector. With several banks sharing the risks using CDS route, the safety of each bank increased, which implies that the probability of default by a single bank dropped, however, there was a rise in their joint default probability. Another area of concern was that the credit risk was often transferred to parties with lax regulatory requirements. Such as, the banks transferred their credit risk to various hedge funds that were not regulated. This shifting of the regulation is referred to as “regulatory arbitrage” and is more like shirking of legal responsibilities. If the risks are not transferred to the best part then there is a possibility of this coming back to the protection buyer in the form of counterparty default. Granting credit carries an implicit responsibility relating to borrower monitoring. But if the bank can easily surpass the credit risk to another party by going long on CDS, there is a lapse in this commitment. Owing to the opaqueness associated with CDS markets one cannot observe the selling and buying of credit risk. With the spread of the credit risk in the overall economy, the monitoring incentives disappear. The possibility of easy shift of credit risk encourages the banks to grant loans without any adequate consideration. In the recent credit crisis, the moral hazards associated with loans specifically the subprime mortgages, appear to be an important factor. In the case of credit derivative instruments, there is a high probability of making marginal positive returns while there is a low probability of huge losses. On account of the limited liability, its return structure appears attractive to the market participants. As the possibility of huge losses is highly unlikely, many financial institutions and banks earned huge incomes by selling CDSs. But given the opaque nature of the CDS market, this form of risk-taking was left out of the purview of market discipline. This resulted in the occurrence of the highly unlikely tail event. This has raised serious concerns about the ways to contain the risks associated with this form of structured derivative product (Hakenes & Schnabel, “The Regulation of Credit Derivative Markets”). Necessity of regulation The recent financial turmoil has changed the peoples’ perception regarding the benefits associated with credit risk instruments. Owing to the downsides of the credit risk instruments regulation of the credit derivative markets has become necessary. In determining the reasons for such restrictions, it is important to distinguish between the varying perspectives prevailing ex-ante and ex-post the crisis. From the ex-post view, after the expiry of CDS, either the seller or buyer made losses. But regulation does not seem to be justified by the loss of money. From an ex-ante view, the contracting parties were not forced to enter into a contract. This means that both the parties must have considered CDS to be beneficial. Therefore, the need for regulatory restrictions is on account of some “externality problem” i.e. an adverse impact of these derivative instruments on another party (Hakenes & Schnabel, “The Regulation of Credit Derivative Markets”). Regulatory measures and their potential impact The regulatory restrictions that have for long been considered for the regulating the credit derivatives market include transparency, ban on CDS (Credit Default Swaps), standardization, establishing a central counterparty, capital adequacy and collaterals. CDS ban- This seems to be the most drastic measure. Given the aforementioned benefits of these financial instruments, a total ban on CDS does not look very desirable. This ban can be softened a bit by banning the trading of naked CDS i.e. when the CDS buyer does not have possession of the underlying asset. This buyer of a naked CDS is similar to that of an individual short-selling a bond. Therefore, the buyer of CDS would benefit if the bond defaults. Consequently, the reasons for the ban on CDS is similar to short selling of stocks, as short sales has already been banned in various countries since the inception of the crisis. If this prohibition is implemented, it would amount to a blanket ban on CDS. This will limit the use of CDS for merely hedging activities and would prevent speculation. Nevertheless, the speculation has also yielded some vital information about the companies. It does not look very justified to seek a complete ban on the CDS. But there are certain financial instruments like CDS, having asset backed securities as underlying, the benefits of which are highly doubtful. Therefore, a ban on these instruments appears to be justified. Increased transparency- The ambiguity of the exposurs in credit default swap markets spurred the crisis in many ways. It was increasingly difficult for the various market participants to evaluate the risk of the other players in the industry. This implies there was no market discipline so as to curb the level of risk. Besides drying up the liquidity in the interbank markets, which led to the spread of the global contagion, it became nearly impossible for the regulatory bodies to identify and prohibit such risk concentrations. An improved transparency will help in mitigating the problems associated with moral hazards. The recent initiative by “Depository Trust & Clearing Corporation (DTCC)” to disclose more information with respect to the CDS cleared by them is a significant move in this direction. However, this may not prove to be sufficient due to which the regulators are considering more disclosures on “large exposures” in the credit risk markets to the general public. One more way of increasing transparency is the “forced compression” of all outstanding positions in the CDS contracts. This means the multilateral or bilateral termination of the credit risk contracts by the identification and removal of offsetting positions. Another area that deserves consideration relates to clarity and understanding of the disclosed information as the terms and conditions of such contracts is highly complex. Standardization- An important argument in favor of standardization is that it improves the level of transparency. Standardization would facilitate better risk assessment of a CDS contract. The existence of a well operating “secondary market” will improve pricing efficiencies and lower the probability of price manipulations. The industry is also keen on adopting further standardization, thereby, pushing aside the need for any regulations with respect to standardization. Collaterals- Using collateral is a way of mitigating counterparty risk. Margin requirements play a vital role in credit default swap markets. Margin requirements help in lowering the counterparty risk. However, the requirement to maintain margin gives rise to additional risks such as ‘liquidity risk’. If the counterparties have to raise additional collateral at a very short notice it can create severe liquidity crisis. As shown by Brunnermeier & Pederson (2009), during crisis situations “market liquidity and funding liquidity” are found to be mutually reinforcing which may create “liquidity spiral”. Therefore, the margin can have a destabilizing effect and can aggravate the crisis (Hakenes & Schnabel, “The Regulation of Credit Derivative Markets”). Establishing a central counterparty- The risk of a counterparty default in the credit risk market can be mitigated by creating a “central counterparty (CCP)” that can act as a “clearing house”. The main advantage of this form of arrangement is that it will lower the probability of “multilateral netting of credit exposures” thereby reducing the counterparty risk. The establishment of a CCP would mean that the risk will now get concentrated in one place i.e. the clearing house. This calls for a strengthened risk management, strong supervisory control and a sound financial back-up. Strict criteria relating to margin maintenance and membership play a crucial part in ensuring CCP’s credibility. This would mean an additional back-up for the CCP like government guarantee. Consequently, strict regulation is needed to deter the market participants from shifting the risks to the CCP and thereon to the payers of taxes. The other obstacles in the creation of a CCP include the over-the-counter nature of CDFS transactions. On account of their low liquidity, it creates valuation related problems ultimately impacting the margin requirements. This issue can be tackled by maintaining a minimum level of standardization and excluding complicated products from CCP (Hakenes & Schnabel, “The Regulation of Credit Derivative Markets”). Conclusion In short, any regulatory restriction must consider the benefits derived by an economy from the credit derivative markets. A blanket or complete ban on these instruments is not desirable. Regulations are necessary in places where there are clear signs of market failure. Besides it is a known fact that any excessive regulation will lead to evasive behavior by some market participants thereby proving to be unproductive and even counterproductive. In the end, there should be at least some room for financial innovation. The financial innovations like currency swap and interest rate swaps have aided economic growth in the past by assuring the businesses of fixed returns on the value of their investments thereby boosting their initiatives to make new investments. Despite the existing political pressure to mitigate the crisis situation by introducing stricter regulations, it may not necessarily lead to greater financial stability. Reference Hakenes, H. Schnabel, I. The Regulation of Credit Derivative Markets. No date. Macroeconomic Stability and Financial Regulation: Key Issues for the G20. March 4, 2011. . Piazza, R. Financial Innovation and Risk, The Role of Information. 2010. International Monetary Fund. March 4, 2011. . The Brookings Institutioon. The Pros and Cons of Financial Innovation. 2011. Brookings. . Walden University. New Foreign Monetary Strategy. 2011. The Effects of Financial Innovation on Policies. March 4, 2011. . Bibliography Baily, N.M. Consumer financial protection: advantages, dangers and should it be a new agency?. 2009. The PEW Economic Policy Department. . Read More