This paper discusses the impacts that financial innovation products have on the stability of the global economy.
Throughout human development, innovation has been noted to take the center stage in almost every aspect of human life. In human history, people have searched for and pursued new forms in response to opportunities and challenges that have been encountered in the struggles in way of living. Innovation or creativity has led to many scientific revolutions which have enhanced financial capability and economic prosperity. Financial innovation refers to an on-going process whereby, corporations experiment with an aim of producing products and services which are more effective and efficient which are different from those of their competitors. This is usually in response to either a sudden or gradual alterations or shifts within the economy. The process of financial innovation involves financial corporations inventing brand new classes of services/products, modification of their prevailing products/services, and integrating various characteristics of a varied range of products which render the financial intermediate very efficient (Sánchez 2010, p.27). This paper discusses the impacts that financial innovation products have on the stability of the global economy.
In economic sector/industry, innovation seeks a positive change that is aimed at bettering a service or product by increasing the product value and both the client and the producers’ value (Mwangi 2013, p. 1). Financial innovation products that increase productivity are the basic source of cumulative wealth within an economy. From a broad perspective, financial innovation encompasses any means by which finance and financial systems become modernized. This perspective entails new and renovated financial mechanisms, bodies, practices, and marketplaces. Historically, one can find a significant foundation for the current financial systems. For instance, the 9th century China brought paper money into the world, where the paper money became an exchange bill use by merchants, a system later used by the government in developing fiat money. Further, medieval Europe experienced the founding of corporations which specialized in deposits and lending of funds as well as the other essential functionalities of current day banking. The more recent financial innovation products that the world has witnessed include debit and credit cards and derivatives which include banking products such as Automated Teller Machines, electronic payment systems, and procedures including credit-scoring schemes (Sánchez 2010, p.27).
The speed and extent of sophistication of financial innovation products have highly increased over the last half of the century owing to the rapid global economic upsurge, globalization, financial freedom, response to governments’ regularizations, the emergence of new legal mechanisms and technological advancement (Dabrowski 2017, p. 8). From a market perspective, the sources of financial innovation products can be grouped into two wide categories which include; advancement in information computing technology and transformations in economic environments (Sánchez 2010, p.27). The former category refers to products and services that have been built with basis on new technological potentials that reduce the cost for acquisition and dispensation of information and render financial transactions highly efficient.
The ostensible examples of these products and services include automated underwriting methods, mobile banking, electronic business forums for forex, and capital products/services (Dabrowski 2017, p. 12). The latter category of financial innovation products entails transformations in the market and regulations that the economic proxies experience. For instance, the relinquishment of the Bretton Woods fixed exchange rate scheme and the raised rate and unpredictability of the global inflation in the years after 1970 led to credit products/services including flexible mortgage rates in the US, and extended the utilization of a number of foreign exchange and interest rate determinations (Sánchez 2010, p.27).
The Impacts of Financial Innovation Products
From the description given above, it then is no surprise that financial innovation products increase material well-being. Particularly, financial innovation products have facilitated the efficient attainment of the economic objective by individuals and businesses which has consequently enlarged their potential for mutually profitable exchange of goods and services (Johnson & Kwak 2012, p. 1). Financial innovation products increase the selection of goods and services available and facilitate intermediation which promotes savings and channels the resources to the highly productive usages. It has the possibility to broaden the accessibility of credit, facilitate the refinancing of obligations and permit better allotment of risk, which matches the supply risk mechanisms to the demand of entrepreneurs ready to tolerate it. Financial innovation can also motivate technological advancement in instances where necessities for information technology create new technology ventures and prompt their funding like in instances of venture capital (Sánchez 2010, p.27).
Consequently, financial innovation products can reduce the price of capital, stimulate better efficacy, and facilitate the smoothening of consumption and entrepreneurial resolutions with substantial profits for homes and firms. As a result of expanding of financial markets, financial innovation products spur economic development of the different nations in the globe (Mishra 2008, p. 3). When the financial markets of the various countries in the globe increase their productivity level, the global economy runs smoothly. However, there are two limitations of financial innovation products to the independent economies of different countries as well as internationally. One entails the probability that some of the products may have been built with an aim of circumventing taxes and regulations of a particular country or trade regions. The second limitation is that the usage allotted to specific products may lead to financial instability (Sánchez 2010, p.27).
There are two sides of the impacts on the global economy; innovation-growth and innovation-fragility. The proponents of the former notion surmise that financial innovation products help in the reduction of agency costs, facilitation of risk-sharing, completion of the market, and eventual improvements of allocative efficiency and economic spurring. The latter notion concentrates on the shortcomings of the financial innovation products on the economic sector identifying it as the causative agent of the 2008 worldwide financial crisis. Products led to an unmatched credit increment which aided in feeding the boom and the resulting bust in mortgage prices by generating security thought to be harmless but led the economies into neglected risks. The innovation-fragility proponents argue that it helped financial institutions and banks to exploit entrepreneurs’ lack of full understanding of financial markets (Beck et al., 2012, para. 1).
When financial innovation products are related to a set of real and financial sector results, the following perspectives are gained. Globally, countries where financial systems spend more in developing financial innovation products, growth opportunities are easily translated to GDP (Coplin 2014, p. 1). The economic sectors that depend majorly on external finance and more on research and technological development activities are able to grow more swiftly in nations where financial organizations spend well in financial innovation products development (Boot & Marinč 2010, p. 2). Nevertheless, the same economic sectors exhibit a volatile growth. In countries in which banking institutions spend more on financial innovation products development, the countries become fragile owing to the higher profit volatility of banking institutions in these countries. This notion is evident from the fact that the banking institutions which had spent much on these products before the global financial crisis of 2008 experienced reduced profits in terms of total assets and equity.
The two perspectives about the impacts of financial innovations products on the global economy have been widely contended by researchers. Some researchers suggest that products facilitate the growth and progress of global economies and aid the economies in operation, the two of which are the eventual objective of a financial system. Beck et al (2012) provide various theories on the effects of financial innovation products where the traditional-innovation growth perspective asserts that the financial innovation products enhance both the quantity and quality of financial systems such as banks, aid in risk-sharing and enhances efficiency. Beck et al (2012) further argue that financial innovation products have contributed greatly to the reduction of the instability of economic undertakings in the initial portion of the 21st century and use the examples of securities/stock market and internet banking.
Michalopoulos et al (2011) argue that over the past few centuries, these products have proved to be the driving forces of financial and economic progression. Financial innovation products have become the backup for specialized lenders and investment financial institutions that funded the railroad in the 19th century. They accelerate the speed of the growth of the economies and the rate of convergence of the economies (Michalopoulos et al. 2011, p.3 ). These two aforementioned effects boost growth by improving the efficacy of resource allotment, not by just improving capital accumulation. Theories explored by Michalopoulos et al (2011) indicate that economies that have financial innovation products tend to develop swifter than the counterparts that do not have them. Financial innovation products have the power to raise the worth of all firms independently by a complex network of contracts which bind all stakeholders of the economy. Financial innovation products are have led to a major reduction in interest rates of housing loans (Palmerio 2009, p.527). Further, certain products like securitization have been recognized as a vitally innovative venture for credit markets.
On the other side, financial innovation products have not had a clear evidence of how they boost the economy, apart from a few such as the ATM. Products such as securitization intensified the risk and vulnerability of the global economies. Securitization amongst other products of financial innovation encourages limited standards of procedures and ineffectual examination of loans since each faction in the lending relies negligently on the other to undertake a thorough investigation of the borrowers. Beck (2012) give subprime mortgages to elucidate their view of financial innovation as a detriment to the world economy. This instance is where entrepreneurs who bought mortgage-backed securities were less keen on these them, leaving financial firms and credit agencies less aware of the risks, thus was unable to examine the risks which caused the 2008 global financial crisis.
Financial innovation products such as securitization and derivatives contribute to aggressive risk-taking and a decrease in loan standards which renders the global economy fragile. Some products limit client resistance to loans through confusion using equivocal terms in contracts (Mishra & Pradhan 2008, p. 29). The administration of financial innovation products in the past have been in low tax-havens which result in an unregulated structure which leads to a growth of shadow banking arrangements that were the epicenter of causes of the financial crisis of 2008. According to Burlamaqui and Kregel (2005), financial innovation products have a tendency of decreasing the transparency of risks that are conveyed on the system thereby elevating the danger of the always increasing financial risks as well as the persistent reduction in comprehension of the non-sureties (Burlamaqui & Kregel 2005, p. 20). These products unintentionally aid financial firms avoid liability for losses since they shift the ventures off the balance sheets unto the unaware entrepreneurs. These products, therefore, aid in changing mediators, permitting them to alter the extent of risks regarding their undertakings.
According to Boot and Arnold (2011), financial innovation products bring about pointless complexities making it hard for managers to comprehend what the other staffs are doing. This impedes the ability of the boards to supervise operations and complicates the ability of the entrepreneurs to understand the risks they are taking which eventually leads to the whole fragility and vulnerability of the financial and economic sectors such of which harmfully impacted the global economy in the crisis (Johnson & Kwak 2012, p. 7). Notably, the financial industry in nations with banking institutions having a small market share, swifter asset growth, and intensified shares of current intermediation undertakings like selling securities are fragile. This is ascribed to the increased benefit volatility of banking institutions with high financial innovation products prevalence.
Financial innovations have had both positive and negative impacts on the global economy. The various technological advancements that have led to seamless transactions on a global platform have been instrumental in the process of globalization. Financial innovation products increase the level of saving and capital accumulation, therefore spurring economic growth. The negative impacts of the financial innovation products are evident by the global financial crisis of 2008. They are in a way opportunistic since the intermediaries are given opportunities to exploit unsuspecting borrows. Left unchecked, the risks of the financial innovation products could lead the world into another economic crisis.