Archive for July 21st, 2008

It is hightime that we review financial innovation

July 21, 2008

How much do things change in an year’s time.

In 2007, Reserve Bank of Australia conducted its Annual conference and the theme was – The Structure and Resilience of the Financial System. In the conference a paper on benefits of financial innovation was presented by Rob Hamilton, Nigel Jenkinson and Adrian Penalver. The authors do provide fall-outs of fin innov. but are more optimistic of its benefits than its fall-outs. The discussant of their paper – Jonathan Fiechter had raised some questions suggesting all is not well with fin innovation.

In 2008, RBA conference has the theme – Lessons from the Financial Turmoil of 2007 and 2008 (what else) and in this two of the authors of the earlier paper review financial innovation again. And this time, they highlight more risks.

I have never really understand the term Financial Innovation. What does it really mean? I think best way to understand it is to first understand the function of financial systems. As per Ross Levine, the best authority on the subject, a financial system has five functions:

  • Produce information ex ante about possible investments and allocate capital
  • Monitor investments and exert corporate governance after providing finance
  • Facilitate the trading, diversification, and management of risk
  • Mobilize and pool savings
  • Ease the exchange of goods and services

 

 So, any innovation should be broadly based to deliver any of the above 5 functions better. Isn’t it?

It is easy to see where all fin innovation is centred- the third function. Most of the fin innovation literature is focused on facilitating the trading, diversification, and management of risk. You hardly see anything happening on the other four and that is where I see most of the problems.  I am not saying there are no attempts, but they are very few given the issues.

For instance, the 2 function – Monitor investments and exert corporate governance after providing finance- is where most of the current and all crisis problems exist. However, we don’t see any innovative ways to tackle this problem and what we see is the usual responses- tight supervision and regulation which is opposed and we have a distorted (full of regulatory arbitrage system).

Likewise, the 4th function – Mobilize and pool savings – is hardly given any thought.  The best talent is usually deployed to work on the third function and we have very slow progress on this matter. Worst of all, because of not adequate work on the second function, the flow of savings in financial markets become highly pro-cyclical- is high in good times and disappears in bad times.

One of the main problem is experts think 3rd function as the sole function of a financial system. It is time we set this agenda right and make work on finance/financial innovation more balanced. Otherwise, finance is always going to be questioned everytime things go wrong.

PS. I came across a very useful paper by Bob Shiller which focuses on the 3rd function but is centred on households.  He talks about using fianncial innovation for managing risks of housing prices, oil and longevity.

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Assorted Links

July 21, 2008

1. WSJ Blog points for ECB credibility is the key 

2. Krugman says oil prices are expected to decline

3. Rodrik points to the recent storming of Karachi Stock Exchange


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