Causes for Financial Innovation

Financial innovation is the process of creating new financial products, services, or processes.

Financial innovation has come via advances over time in financial instruments and payment systems used in the lending and borrowing of funds. These changes which include updates in technology, risk transfer, and credit and equity generation have increased available credit for borrowers and given banks new and less costly ways to raise equity capital.

Financial innovation is the act of creating new financial instruments as well as new financial technologies, institutions, and markets. Recent financial innovations include hedge funds, private equity, weather derivatives, retail-structured products, exchange-traded funds, multi-family offices, and Islamic bonds (Sukuk). The shadow banking system has spawned an array of financial innovations including mortgage-backed securities products and collateralized debt obligations (CDOs).

There are 3 categories of innovation: institutional, product, and process. Institutional innovations relate to the creation of new types of financial firms such as specialist credit card firms like Capital One, electronic trading platforms such as Charles Schwab Corporation, and direct banks. Product innovation relates to new products such as derivatives, securitization, and foreign currency mortgages. Process innovations relate to new ways of doing financial business, including online banking and telephone banking.

Economic theory has much to say about what types of securities should exist, and why some may not exist (why some markets should be “incomplete”) but little to say about why new types of securities should come into existence.

One interpretation of the Modigliani-Miller theorem is that taxes and regulation are the only reasons for investors to care what kinds of securities firm’s issue, whether debt, equity, or something else. The theorem states that the structure of a firm’s liabilities should have no bearing on its net worth (absent taxes). The securities may trade at different prices depending on their composition, but they must ultimately add up to the same value.

Furthermore, there should be little demand for specific types of securities. The capital asset pricing model, first developed by Jack L. Treynor and William F. Sharpe, suggests that investors should fully diversify and their portfolios should be a mixture of the “market” and a risk-free investment. Investors with different risk/return goals can use leverage to increase the ratio of the market return to the risk-free return in their portfolios. However, Richard Roll argued that this model was incorrect, because investors cannot invest in the entire market. This implies there should be demand for instruments that open up new types of investment opportunities (since this gets investors closer to being able to buy the entire market), but not for instruments that merely repackage existing risks.

If the world existed as the Arrow-Debreu model posits, then there would be no need for financial innovation. The model assumes that investors are able to purchase securities that pay off if and only if a certain state of the world occurs. Investors can then combine these securities to create portfolios that have whatever payoff they desire. The fundamental theorem of finance states that the price of assembling such a portfolio will be equal to its expected value under the appropriate risk-neutral measure.

Remittances are another area that financial innovation is transforming. Remittances are funds that expatriates send back to his or her country of origin via wire, mail, or online transfer. Given the volume of these transfers worldwide, remittances are economically significant for many of the countries that receive them. In the early 2000s, the World Bank established a database, where people could compare prices of different transfer services. The Gates Foundation subsequently began tracking remittances in 2011. Western Union and Moneygram once monopolized remittances; however, in recent years startups such as Transferwise and Wave have competed with their lower cost apps.

Finally, mobile banking has made major innovations for retail customers. Today, many banks like T.D. Bank offer comprehensive apps with options to deposit checks, pay for merchandise, transfer money to a friend, or find an ATM instantly. It is still important for customers to establish a secure connection before logging into a mobile banking app in order to avoid his or her personal information being compromised.

Spanning the market

Some types of financial instrument became prominent after macroeconomic conditions forced investors to be more aware of the need to hedge certain types of risk.

• Interest rate swaps were developed in the early 1980s after interest rates skyrocketed
• Credit default swaps were developed in the early 2000s after the recession beginning in 2001 led to the highest corporate-bond default rate in 2002 since the Great Depression

It is widely believed there are six primary causes for financial innovation, they are:

• Increased volatility of interest rates, inflation, equity prices, and exchange rates.
• Advances in computer and telecommunications technologies.
• Greater sophistication and educational training among professional market participants.
• Financial intermediary competition.
• Incentives to get around existing tax laws.
• Changing global patterns of financial wealth.

Financial innovation can also be classified in three main categories. Market broadening instruments, which increase market liquidity and availability of funds; risk management instruments, which redistribute financial risk to those who are more willing to bear the risk; and arbitraging instruments and processes, which allow the investor to take advantage of certain market perceptions such as information, taxation and regulation. No matter the cause or category of the financial innovation the industry will benefit if the innovation stands the test of time and improves upon the efficiency of the financial market.

Takeaways

Financial innovation refers to the process of creating new financial or investment products, services, or processes.

These changes can include updated technology, risk management, risk transfer, credit and equity generation, as well as many other innovations.

Recent financial innovations have included crowdfunding, mobile banking technology, and remittance technology.