Financial innovation

inSight

27 Sep 2007

Financial innovation

The risks associated with financial innovation need to be managed – but overreaction could stifle its development.

There are considerable differences of opinion about how to describe the current conditions in the money markets in the US and Europe. Terms like dislocation, nervousness, turmoil and crisis have been used. There is considerable uncertainty over the extent of the problems and their effects, and I am sure in the fullness of time authoritative analyses and an appropriate description will emerge. What seems clear now is that, once again, financial innovation has run ahead of the ability of many players in the financial markets, including regulators, to understand and manage the associated risks.

It is obviously too early to talk about remedies, or even articulate the causes of the problem, given that all concerned are still trying hard to contain the "dislocation" in the money markets. But there is already quite strong scepticism developing towards financial innovation generally. Many in the emerging markets, for example, now consider the less developed state of their debt markets as a blessing in disguise, just as they shunned and actually rolled back the efforts towards financial liberalisation and globalisation in the wake of the financial crisis in Asia in 1997-98. I think it would be regrettable if this attitude were to be repeated.

Lest it be forgotten, the benefits derived from financial innovation all over the world have been enormous. Higher efficiency and greater diversity in financial intermediation brought about by financial innovation have increased the productivity and growth potential of the economy, and led to much greater economic welfare. Fund raisers enjoy greater access to funds at lower costs. Investors have a greater variety of risk-return profiles to choose from to achieve higher risk-adjusted returns. Financial intermediaries employ more people and offer more attractive remuneration to award innovative efforts.

Theoretically, although this is not always the case in practice, financial innovation helps achieve financial stability, for example, by creating more diversified channels for financial intermediation. But it is the uncertainty about the implications for financial stability that have cast doubt on the merits of financial innovation. If we look back in history, banking crises were often preceded by financial innovation, although it is difficult to be precise about cause and effect. One thing for sure is that financial liberalisation and increased competition, which encourage innovation, have led to excessive risk taking by some banks, to the extent of threatening their solvency in times of stress. A clear example of this is the period when financial derivatives came into being and proliferated. Products such as options and futures, which are now considered common tools for hedging, managing risk and investment positioning, have quite a long history of causing financial turmoil. Names like Metallgesellschaft and Orange County were prominent in the financial news in the early nineties: the former lost over a billion US dollars in oil futures and the latter an even greater amount in interest-rate futures. Readers may also remember the losses of Barings in Singapore in Nekkei Index futures. In Hong Kong, there was the "double play" involving Hang Seng Index futures during the Asian financial turmoil in 1997-98.

We all learn from history. Financial innovation brings forth new, often hidden risks. Market players may not always be able to understand and manage these risks. Yet the incentives surrounding financial innovation greatly encourage indulgence and leverage, to the extent of turning hidden risks, to which individual players are exposed, into a hidden vulnerability of the whole financial system to shocks. With no established or readily available remedies to deal with shocks that occur when the unknown risks materialise, systemic financial instability ensues.

The forces generated by financial innovation are potent. They need to be harnessed if the benefits are to be realised fully and sustainably. This involves devoting greater effort to understanding and managing the associated risks. The question, as always, is how. Finding the right answers is never easy, but I am confident that the question will be answered as the international financial community, working with the financial authorities, rises to the challenge, perhaps when the current turmoil subsides. There have been early calls for tighter regulation and more government oversight, but I think it is also important to avoid knee-jerk reactions that may stifle financial innovation.

Joseph Yam
27 September 2007

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