Introduction
Tuffano (4) defines financial innovation as “the act of creating and popularizing new financial instruments as well as new financial technologies, institutions and markets”. The reasons for innovations are generally to increase profitability in the financial. Financial innovation is seen with regard to financial products, financial institutions and the processes that these institutions employ. Financial innovation is also seen in the financial markets by introducing many alternative investment options and reducing the transaction process and transaction cost while increasing returns.
According to Dynan, Elmendorf and Sichel (3), financial innovation is one of the ways of solving global economic crises. Cavanna (15) defines financial innovation as a cause and a result of many structural changes observed in the financial systems today. The paper shall explore various areas of financial innovation and the impact that this has on risk return theories. To do this I will consider literature review from four sources and later give a conclusion on the impact of financial innovation on risk and return. All this will be done with regard to capital fund management.
Examples of innovations
According toTuffano (4) financial innovation can be divided into innovative products and innovative processes. Innovations in products include the introduction of derivative contracts, new corporate securities or new pooled investment Cavanna (15) describes the emergence of new instruments as a major financial innovation. Innovations in processes include new means of distributing securities, processing transactions, or pricing transactions.
Innovation in products include the introduction of new derivatives, alternative risk transfer products, exchange traded funds and tax deductible equities. Other recent innovations in the capital market include those in mortgage refinancing and the ability to extract equity from homes and also the rise in exotic securities (Farrel, Bloomberg Business Week).
According to Farrel (Bloomberg Business Week), the need for financial innovation has been brought by the growth in population and the increase in the number of people and markets that need financial solutions and especially with the spread in wealth from the advanced economies and into other emerging markets. The financial market is an important economic driver and capital markets are an important social and economic institution that communicates all kinds of information about the financial situation of an economy.
One of the major financial innovations in the 1980s was securitization which is described as “financial intermediation with a counterpart in a tradable financial asset” and the growth in off balance sheet business of banks.
The results of innovation
Some of the results of innovation in the capital fund management sectors include the transfer of risk to the ultimate lenders, creation of many intermediaries which increases risk sharing and efficiency of the financial system. According to Cavanna (15, there has been increase in the number of new markets and rise in the volume of new capital market issues. Innovation has also helped in solving the special risks encountered in the international financial market.
Innovations are also classified according to their results into risk transferring innovations; which help in risk reduction or risk protection, liquidity enhancing; which increase liquidity of instruments, credit generating innovations which increase access to particular kinds of credit and hence increase total volume of credit, and equity generating innovations (Cavanna 23-25).
Increased attention to financial innovation, which is a continuous process that has occurred over many years, is a major cause of reduced volatility in economies. (Dynan et al 4). Changes in financial systems such as improved assessment and pricing of risks, expanded lending to households with no need for production of proper collateral, use of more forms of securities for loans and development of a market for riskier debt instruments are the reasons for the reduction in volatility. In the study by Dynan and colleagues (5) the reduction in the responsiveness of housing investment to interest rates is a major contribution brought about by financial innovation.
The benefits of financial innovation are seen by financial intermediaries in the improvement of assessment and pricing of risks. Lenders are now able to collect information about the creditworthiness of borrowers and also setting interest rates and managing their risks.
The changes brought by financial innovation are also seen in the change of the financial sector with the change from using financial institutions as intermediaries to the use of market. The increased use of markets has lead to reduction in transaction cost and reduced risk due to risk sharing among the different intermediaries.
Dynan and colleagues (4) note that there is an increased market for new high risk debt instruments. This implies an increase in return in the financial market since investors will only take up more risk if it is associated with high return. Innovations in the processes in the financial market also include changes in government regulations that affect the financial markets, (Dynan et al 9). These changes have helped in increasing the returns and reducing the risks in the financial markets. Farrel (Bloomberg Business Week) also agrees that the growth in the financial intermediaries is a major boast to the financial market and this call for greater regulation in this sector. Innovation in the financial market should focus on increasing transparency, increasing the capital and reducing leverage. Innovation in policies has also contributed to the growth of new financial products and the globalization of the financial market (Dynan et al10). Globalization is especially important in the reduction of financial risk and the increase in financial returns.
According to Finnerty (as quoted by Tuffano 5), the factions served by product innovation include relocating risk, increasing liquidity, reducing agency costs, reducing transaction costs, reducing taxes or reducing the hindrances caused by regulations.
The issue of reduction in market volatility is described by Tuffano (13), who goes on to expound on the importance of financial intermediaries in reducing financial risk. These financial intermediaries are also a major source of financial innovations and they aid in increasing financial return by reducing agency and marketing costs. The improved quality and quantity of information which is caused by government forces and market forces has also increased innovation and lead to a reduction in information cost. The ability of investors to access market information has contributed to reduction in market costs and improved financial services.
Conclusion
Financial innovation is a major driver of growth in the financial sector which has gained continuous importance as an important sector of the economy. There has been an increase in the number and types of financial instruments which has lead to a reduction in risks and an increase in return. Also the availability of a variety of products enables investors to spread their risk and also reduces the cost of financial transactions there is however a growing concern of the impact of innovation on market volatility. Market regulation should be enhanced to reduce this volatility especially through regulation on quality and quantity of information that the financial markets provide.
Works Cited
Cavanna, Henry. Financial Innovation. London: Routledge, 2992. Print.
Dynan, Elmendorf, Sichel, Can Financial Innovation Help To Explain The Reduced Volatility Of Economic Activities?, Division Of Research & Statistics And Monetary Affairs, Federal Reserve Board Washington D.C. 2005. Web.
Farrel. Financial Innovation Is Dangerous but Necessary.Bloomberg Business Week, 2010. Web.
Tufano, Peter. Financial Innovation, Harvard Business School, Boston Massachusetts, 2002, Web.