Financial markets have always undergone changes . However since the 70s the speed of change has accelerated enormously . New types of financial instruments, financial markets and techniques have been developed. The most significant innovations have been the financial derivatives, e.g. futures, options and swaps and the development of securitisation which have mainly been created to manage risk and provide liquidity. The market for these instruments has become huge – by some estimates in excess of $100 trillion .
History shows that financial innovation has been a critical and persistent part of the economic landscape. But why has it been like that? First of all for a better understanding it is necessary to define the term ‘financial innovation’. Financial innovation is described by Van Horne as “the life blood of efficient and responsive capital markets” . He emphasis that it is part of the bedrock of our financial system. Merton views financial innovation as “the engine driving the financial system towards its goal of improving the performance of what economists call the real economy”.
Other authors define financial innovation as “the design of new financial instruments and techniques of financial intermediation, structural change in the financial system, with the appearance of new financial markets and changes in organisation and behaviour of institutions” as well as “the design of new financial instruments or the packaging together of existing financial instruments” . There is a general recognition of the particular importance of financial innovations for the wealth of a society.
This paper outlines the nature and main features of innovation in financial markets and suggests what factors may stimulate the apparent increase in the rate of innovation since the 1970s with a particular view on the role of banks. The final part discusses the question if financial innovations have been beneficial for borrowers and lenders?
Table of Contents
1 Introduction
2 Nature of Financial Innovation
3 Stimuli for change
4 Types and features of financial innovation
5 Pilbeam’s criteria of diversification
6 Discussion: Have financial innovations been beneficial for borrowers and lenders?
7 Conclusion
Objectives and Key Themes
This paper examines the rapid evolution of financial markets since the 1970s, aiming to define financial innovation and identify the primary drivers behind this acceleration. It explores the diverse types of innovations, analyzes their impact on market efficiency, and evaluates whether these developments provide a net benefit to borrowers and lenders while considering inherent risks and societal costs.
- Theoretical definitions of financial innovation.
- Key stimuli for change, including regulation, technology, and globalization.
- Categorization of innovation into institutional, process, and product types.
- Risk management and the balancing of economic efficiency against market volatility.
Excerpt from the Book
6 Discussion: Have financial innovations been beneficial for borrowers and lenders?
Financial innovations raise various benefits as well as costs for borrowers and lenders. In the following the benefits and the costs of financial innovations are discussed.
A large advantage of financial innovations is that they increase the market liquidity, provide credit and support economic activities. An important example is the world liquidity which grew tenfold in the 1980s. This underlines he fact that financial innovations are of strategic importance for the world economy.
Previously already mentioned, Morton states that “financial innovation is viewed as the engine driving the financial system towards its goal of improving the performance of what economists call the ‘real economy’”. He concludes that financial innovation has produced enormous social welfare for a society.
Further computer and telecommunication technology reduces the transaction costs of managing, moving, and monitoring funds. This leads to enormous savings for financial institutions as well as for the customers. Financial innovations save time and money for borrowers and lenders, for example through cash machines or home banking. Transactions are made easy because funds are more fungible because they can be easily converted from one type of financial innovation to another. The market is more efficient by reducing the cost of financial intermediation to consumers of financial services.
Summary of Chapters
1 Introduction: Provides a foundational definition of financial innovation and highlights its accelerating pace since the 1970s.
2 Nature of Financial Innovation: Outlines the characteristics of financial innovation, focusing on product variety, marketability, and the internationalization of services.
3 Stimuli for change: Analyzes the diverse factors driving innovation, including regulatory shifts, technological progress, and macroeconomic conditions.
4 Types and features of financial innovation: Distinguishes between institutional, process, and product innovations within the financial sector.
5 Pilbeam’s criteria of diversification: Explores a specific classification framework for innovation based on market broadening, risk management, and pricing.
6 Discussion: Have financial innovations been beneficial for borrowers and lenders?: Weighs the liquidity and cost-efficiency benefits against the risks of increased volatility and complexity.
7 Conclusion: Summarizes the impact of financial innovations on market efficiency and offers a cautious outlook on future progress.
Keywords
Financial Innovation, Financial Markets, Derivatives, Securitisation, Financial Intermediation, Market Liquidity, Deregulation, Technological Progress, Risk Management, Economic Welfare, Monetary Policy, Volatility, Financial Institutions.
Frequently Asked Questions
What is the core focus of this publication?
The work provides a comprehensive overview of financial innovation, examining why it has accelerated significantly since the 1970s and how it has reshaped the financial landscape.
What are the primary themes discussed in the text?
The main themes include the definition of financial innovation, the various drivers like technology and deregulation, the categorization of financial products, and the ongoing debate regarding their benefits versus risks.
What is the central research question?
The paper seeks to understand the nature of financial innovation and specifically questions whether these advancements have ultimately been beneficial for borrowers and lenders.
Which scientific methodology is employed?
The paper utilizes a literature-based analytical approach, synthesizing views from various economists and institutional reports to describe current market evolutions.
What topics are covered in the main body?
The main body covers the theoretical nature of innovation, catalysts for change (taxes, technology), classification of innovation types, and a detailed discussion on efficiency gains versus systemic risks.
Which keywords define this work?
Key terms include financial innovation, market efficiency, securitisation, derivatives, risk management, and regulatory liberalization.
How do 'rebundling' and 'unbundling' function in financial innovation?
These terms refer to the rearrangement of financial institutional functions, allowing firms to manage risks better or offer entirely new service structures to their clients.
What ethical concerns are raised regarding the fast pace of innovation?
The text suggests that rapid technological innovation, such as automated banking, may lead to a loss of human connection and create confusion, particularly for elderly demographics.
- Quote paper
- Volker Schmid (Author), 2004, Financial Innovation - with a particular view on the role of banks, Munich, GRIN Verlag, https://www.grin.com/document/28594
