by Financial innovation can be defined as the act of creating and then popularizing new financial instruments. This implies advances over time in the financial instruments and payment systems used in the lending and borrowing of funds as well as innovations in the payment mechanisms and systems in the economy.
Financial systems provide vital services: they evaluate, screen and allocate capital, monitor the use of that capital, and facilitate transactions and risk management. If financial systems provide these services well, capital will flow to the most promising and deserving firms, promoting and sustaining economic growth. Financial innovation, which is the creation of new securities, markets and institutions, can improve the financial services sector and thereby accelerate economic growth.
These advances include innovations in technology, risk transfer and credit and equity generation. A number of innovations have taken place over time among them; the development of Automated Teller Machines (ATMs); the expansion of credit card usage; Debit cards; Money market funds; Basic forms of securitization; Venture capital funds and interest rate and currency swaps amongst many others.
Advantages of Financial Innovation
Financial innovation has been shown to increase the material wellbeing of economic players. Positive innovation has helped individuals and businesses to attain their economic goals more efficiently, enlarging their possibilities for mutually advantageous exchanges of goods and services.
Financial innovation, by increasing the variety of products available and facilitating intermediation, has promoted savings and channeled these resources to the most productive uses. It has also assisted to widen the availability of credit, help refinance obligations and allow for better allocation of risk, matching the supply of risk instruments to the demand of investors willing to bear it.
Innovation is also at the centre stage of encouraging technological progress when the requirements for information technology generate new technological projects, and induce their funding as in the case of venture capital.
Financial innovation lowers the cost of capital, promotes greater efficiency, and facilitates the smoothing of consumption and investment decisions with considerable benefits for households and corporations. As the new products contribute to the deepening of financial markets, innovation, in turn, fosters economic development.
Financial innovation may also help to moderate business cycle fluctuations. Innovations such as credit cards and home equity loans allow households to keep their consumption smooth, even when their incomes are not. The increased availability of credit to businesses allows them to smooth their spending across short periods when revenues do not cover costs.
The success of any innovation depends on three things. The first is how good the product is to begin with. Some financial products are poorly conceived or designed. Next is the appropriate use of the product: Is the product meant for a particular market or type of risk? And finally, the value of an innovation hinges on the competence of the person implementing it.
Disadvantages of financial innovation
The World financial crisis of 2007‐09 is a sharp reminder that financial innovations can bring substantial costs along with the benefits described above. However, sometimes the costs may outweigh any benefits making such financial innovations negative. Many households lost their homes when falling house prices made it impossible to refinance their subprime mortgages. Many intermediaries underestimated the risks of new financial products and were compelled to deleverage in the crisis. The resulting uncertainty contributed to the seizing up of key markets for liquidity, such as the interbank lending market
Rapid financial innovation can be a source of systemic risk as evidenced during the financial crisis. When financial products without a track record expand rapidly in a buoyant economic environment, investors tend to underestimate the risks that only occur in periods of economic stress. Separately, innovations that help conceal concentrations of risk can make the financial system more vulnerable to a shock. In both cases, the problem is that investors do not obtain adequate compensation for the risks that they take because they do not understand the risks or because the risks are invisible.
