Financial innovation: To do or not to do !

Investopedia defines Financial Innovation as ‘Advances over time in the financial instruments and payment systems used in the lending and borrowing of funds. These changes, which include innovations in technology, risk transfer and credit and equity generation have increased available credit for borrowers and given banks new and less costly ways to raise equity capital.’
Financial Innovation is something that is seen by an individual as a new way by which finance can generate returns, redistribute risk and fuel the economy. Among all the adventures of the mankind – from making huge constructions to global trade – financial innovation is the one which is very unique.
Few financial experts have argued that these new financial contracts are largely the same as in the past; what has changed is the packaging of the instruments and the way they are traded in the market. The new contracts are a transformation of existing financial instruments. This technique is the ‘replicating portfolio’ approach. Once the possibility exists for converting the custom design to a standardized product with low transaction costs, the product is made live to the market. Such kind of product innovation may not succeed every time.

In-numerous financial products in the market have reduced reliance on traditional banks for credit purposes. Some products can be tailored for risk management purposes while others can be used for reduced cost of funding. The basic principles of finance are being extended and reapplied to yield more products.
Consumer financial innovation is not about just borrowing of funds. In USA, “529 plans” which are tax beneficial investment vehicle, has encouraged savings for future higher education. Also, various mutual fund instruments have helped investors in tapping the growing economy advantages.
Apart from this, development of external bonds (also known as the Euro-bonds) sold outside the country of currency in which it is denominated has led to the development of euro-bond market. Credit default swaps (CDS) were introduced to mitigate risks against loan defaults. But, then CDS led to the massive issuance of mortgage backed securities, which have been blamed for sub-prime financial crisis of 2008.
Factors leading to Financial Innovation
There are a numerous factors that have lead to financial innovation on the markets. Few of the key ones are listed below:
Deregulation: The first and the foremost factor that had led to innovation in the financial markets is the deregulation. Deregulation in the financial markets had led to the development of new instruments. New instruments developed, led to further regulation in the financial markets. This had led the financial institutions to compete in the international markets.
Uncertainty: With the growing market developments, there has been established a relationship between the risks associated with the assets and the interest and exchange rates. Asset values have become volatile and in order to protect them financial institutions have developed variety of products to hedge risks.
Data Processing Power: Computer revolution has drastically reduced the cost of financial transactions. Also, it had lead to the development of certain derivative products whose values cannot be calculated on a real time basis without advanced data processing software.
Globalisation & Securitisation: With international trade and investment, demand for international financial services has increased.
Implications of Innovation on Financial Markets
Financial innovations have a direct impact on the financial markets. It majorly impacts the asset prices, international price relationships, and market behaviour; few of the impacts are listed below:
i. Financial market behaviour
ii. Lower transaction costs
iii. Greater liquidity
iv. Greater substitutability
v. Minimized risk with diverse portfolio
vi. Greater competition for financial services
vii. Improved opportunities for investing
viii. International markets relationships
ix. Greater international capital mobility
x. Greater integration of international markets
xi. Equalization of the cost of funds across the countries
xii. Macroeconomic Impact
xiii. Greater impact of changes in currency rates and exchange rates
xiv. Interest rates and credit availability
Indian Markets
India too is a host for financial innovations. Liberalisation and globalisation has led to the integration of the Indian economy and the financial markets with the global markets. Although, the Indian financial markets are not developed completely and have a limited size; there is great scope of growth and expansion. Limited financial instruments availability has controlled corporation’s ability to hedge against risk. The fact remains that almost half the population here does not have bank accounts, and there are financial rigidities in place such as high cash reserve for the banking system and other statutory requirements that generally repress returns. Hence there is a need for financial reform. Several steps have been taken by the RBI and other organisations like SEBI, to meet the growing needs of the Indian markets and to promote innovation.
Reliance Industries became the first Asian company to issue a 100-year Yankee Bond in the US. India also introduced its own version of the Depository Receipt, the IDR which has however, not taken off well with only Standard Chartered Bank issuing its IDR
Recently, the RBI was awarded the 2012 Dufrenoy Prize for its precautionary approach in regulating the derivatives market, and thus facilitating financial innovation in a responsible manner. This prize was instituted by the Observatory for Responsible Innovation (ORI) – an independent international think tank with the purpose of thinking and debating on new measures, concepts, and methods to foster responsibility in innovation.
Financial innovation presupposes unbundling and re-bundling of risks. For financial innovation to take place there has to be a high level of dissatisfaction with the present and concern over future needs. Although the financial innovations have a dark side and create complexity, but there is a positive side as well. The question remains – To innovate or not to innovate!?

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