Financial Innovation - with a particular view on the role of banks

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

References

1 Introduction

Financial markets have always undergone changes^[1]. However since the 70s the speed of change has accelerated enormously^[2]. 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^[3] 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^[4].

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”^[5]. He emphasis that it is part of the bedrock of our financial system. Merton^[6] 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”^[7] as well as “the design of new financial instruments or the packaging together of existing financial instruments”^[8]. There is a general recognition of the particular importance of financial innovations^{[9] [10]} 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?

2 Nature of Financial Innovation

To describe the nature of financial innovation following aspects mentioned by Growland^[11] have to be considered:

Through the increased range and the larger variety of products, gaps in the spectrum of products can be filled by what is called spectrum filling e.g. offering products previously available in other countries, combining characteristics of financial services in different ways or identifying the specific consumer needs with the help of marketing techniques. Secondly, the extent to which financial instruments can be marketed has grown enormously through the creation of new marketable assets e.g. financial futures, options and other derivate products and the increase in secondary marketability by securitisation e.g. of mortgages, commercial loans, credit card loans. Thirdly, two of the most important features of financial innovation are ‘rebundling’ and ‘unbundling’ which means the rearrangement of the functions of financial institutions so that they are able to offer a different range of services and/or manage risks e.g. securitisation; and the take-over of a large conglomerate with a view to retraining the core business and selling off some of the subsidiaries to help finance the take-over. Finally, financial innovation is characterised through the internationalisation of products and suppliers. Internationalisation of products is the creation of services where the raison d’être derives from international factors i.e. travellers’ cheques or credit cards. Internationalisation of supply occurs when it is possible to buy the same product from an overseas as well as from a domestic one.

3 Stimuli for change

Financial innovations occur in response to profit opportunities for financial institutions arising from inefficiencies in financial intermediation or the incompleteness of financial markets^[12]. Many factors account for the apparent increase in the rate of innovation since 1970. Some factors had a very strong impact on this development, e.g. changes in the regulatory-framework and technological progress; but there are also other factors which, though not large, have still had a significant impact. Below the different factors and their effects are described.

Miller^[13] cites that “the major impulses to successful innovations over the past twenty years have come...from regulation and taxes”. The regulatory changes have reduced or removed many restrictions which have, in return, prompted many financial innovations^[14]. This liberalisation has stimulated the financial sector to create financial innovations, one classic example of which is convertibility. On the other hand, the government has tried to prevent more official regulations in order to support the process of deregulation. The major forces behind deregulation have been technology and improving international economic relations.

The 1975 ‘May Day’ in Wall Street and the 1986 ‘Big Bang’ in Britain continued the deregulation process in the capital markets which soon spread all over Europe^[15]. Through the changes in the regulatory-framework, financial institutions were allowed to develop their business, e.g. banks entered the capital and money market and became massively involved in securities trading for their own account.
Further non-financial competitors appeared (e.g. GE, Ford, M&S), which also provided financial services and these started to compete with the banks and each other.

Alteration in tax laws also motivates financial innovation. These changes often emerge when after-tax returns on financial instruments are impacted on by tax legislation. In particular, the changes in the differential taxation of interest and dividend income versus capital-gains income affects the market equilibration process. An example is the Deficit Reduction Act of 1984 which altered the market equilibrium in restriction respectively the use of certain financial products^[16].

As regards the financial system, advances in technology reduce the cost of different services, facilitating the creation of new services and the improvement of existing services. The computer age has lowered the costs of collecting and processing information, calculation, communication and, especially, transaction costs^[17] and, has therefore, dramatically changed the way financial products are provided and priced. A good illustration of the process/product innovation is electronic trading illustrated at the International Stock Exchange^[18].

[...]

^[1] Gowland, D. (1991) “Understanding Macroeconomics”. Edward Elgar Publishing Limited, p. 78.

^[2] Llewellyn, D. T. (1988) “Financial Innovation: A Basic Analysis”, in Paeles De Economica Espanola.

^[3] Buckle, M., Thomson, J.(1998) “The UK Financial System”. Manchester University Press, p. 51.

^[4] Swan, B. (2002) “Can Financial Innovation turn Sour?“ URL: http://www.cansofunds.com/NewSite/resources/2002-financialinnovation.html

^[5] Van Horn, J. (1985) “Of Financial Innovations and Excesses”, The Journal of Finance, vol.11 (3), p. 621.

^[6] Merton, R. C. (1992) “Financial Innovation and Economic Performance”, Journal of Applied Corporate Finance. Volume 4, p. 12-22.

^[7] Buckle, M., Thomson, J.(1998) “The UK Financial System”. Manchester University Press, p. 48.

^[8] Pilbeam, K. (1998) “Finance & Financial Markets”. Macmillan Press Ltd, p. 48.

^[9] Van Horn, J. (1985) “Of Financial Innovations and Excesses”, The Journal of Finance, vol.11 (3).

^[10] Merton, R. C. (1992) “Financial Innovation and Economic Performance”, Journal of Applied Corporate Finance. Volume 4, p. 12-22.

^[11] Gowland, D. (1991) “Understanding Macroeconomics”. Edward Elgar Publishing Limited, p.83 et sqq.

^[12] Van Horn, J. (1985) “Of Financial Innovations and Excesses”, The Journal of Finance, vol.11 (3), p. 622.

^[13] Miller, H. (1986) “Financial Innovation: The Last Twenty Years and the Next”, Journal of Financial and Quantitative Analysis. Volume 21, p. 459-471.

^[14] Van Horn, J. (1985) “Of Financial Innovations and Excesses”, The Journal of Finance, vol.11 (3), p. 623.

^[15] Ravel, J. (1997) “The Recent Evolution of Financial Systems”. Macmillan Press Ltd., p. 18 et sqq.

^[16] Van Horn, J. (1985) “Of Financial Innovations and Excesses”, The Journal of Finance, vol.11 (3), p. 623.

^[17] Ravel, J. (1997) “The Recent Evolution of Financial Systems”. Macmillan Press Ltd., p. 18 et sqq.

^[18] Gowland, D. (1991) “Understanding Macroeconomics”. Edward Elgar Publishing Limited, p. 78.