How innovation happens: The ferment of finance Essay

This article highlights financial innovations which have become a common thing for investors and investment banks currently. According to the article, this may not be the most suitable time for financial innovations given the current global economic problems and the industries regulatory overhaul though the current environment looks perfect for stimulating finance’s innovative products.

With new regulations necessitated by the crisis, as known, these new regulations spark differences of creativity as the “financial engineers try to turn around the new policies and also gain from them.

Martin Chavez, a head of a team of financial experts at Goldman Sachs, says that when a customer wants to take up a specific risk and there is no general solution at hand to the customer’s, it the work of the financial experts at the bank to come up with a derivative that suits the customer’s call rather than say ‘no thanks’ to the customer (The Economist online, 2012).

Sometimes clients want things to happen faster at a time when yields are low, risk is high and the need for investment packages which are designed to assume greater risk can’t put a ceiling on possible losses. Thus, investment banks prefer derivatives-based answers which will promise minimum costs and allow for a restricted amount of returns. Investors are now turning their interests to hedging which is proving vital as asset allocation.

With the need for financial inventiveness to meet the market demands, the investment banker needs meticulous financial management. According to Julie Winkler, working with CME, there are three process for innovation: First, investigation, this ascertains whether the market demands a given product; second, creation, contract conditions are laid out and tests carried out on a small group of voluntary individuals; and, third, validation stage, correspondence from a bigger group of the company departments.

However, investment banks are left with the difficulty of ascertaining the erudition of a client. When an innovation is put in the market, by description it’s not systemic as it may not go well with the intended buyers and sellers, the system regulators and the taxpayers thus it should not have a scale where their flaws can shock the economy.

Basis risk is always a big difficulty for investors. David Howell, the CEO of Pacific Life Re, states, “Investors want something tradable, where they don’t have to make actuarial judgments and can have standardized products.” Many of the derivatives, such as pension funds, require a lot of actuarial expertise at least to say for the normal investor, therefore need for index-based transactions which can be used as a reference point for buyers.

Indices such as rates for quantifying mortality improvement can be used as a reference point for a pension fund buyer (Dalio, 2012). However, there is a need for a market-architect to fill the gap between these two industry players; re-insurer, insurer or investment bank which has the expertise to transact with sellers and is keen to assume the basis risk of indices-based transactions to drive it out to capital markets that is, buyers and sellers.

There is also the longevity risk, which can take decades to come out. That generates another disparity since a bond buyer or seller generally wants to lock up his/her money for about 5 to 10 years and could be short of time as to work as a helpful hedge against individuals living longer.

In conclusion, the article states that there are demanding efforts and risks in creating the financial innovations market. The article suggests that there is need for standardization for its development. As learnt from the economic woes, where some financial market players held a lot of this basis risk and others transferred it to the investors who couldn’t sustain it, intermediaries should be keen in the management of the basis risk, as they could have managed it well and the crisis could not have occurred.

References

Dalio, R., 2012. Man and machine: The economic ideas of the world’s most successful hedge-fund boss. The Economist. Web.

The Economist online. 2012. How innovation happens: The ferment of finance. The Economist. Web.