Regulators must manage the risks of financial innovation while harnessing its potential.
I mentioned in last week's article that a general issue underlying the current financial turmoil is financial innovation and that I would revisit the subject.
Financial innovation improves the efficiency of financial intermediation, enabling some investors to achieve a higher, risk-adjusted rate of return and some borrowers to enjoy greater availability of funds at lower cost. It also allows financial intermediaries to do more business, earn more profit, employ more people, and pay higher salaries and bonuses.
So financial innovation can benefit investors, borrowers and financial intermediaries.
But there is an implicit assumption that must be fulfilled for the benefits of financial innovation to be realised. This is that the starting position is a financial system that is less than efficient in performing the financial intermediation that is essential to economic wellbeing. Interestingly, this assumption is generally true. It is quite common to notice mismatches between the risk profiles of financial instruments available in the financial system and the risk appetites of investors, or a lack of diversity of financial instruments and therefore a lack of choice for investors, or a captive market with financial intermediaries earning what seems to be an abnormal rate of profit.
One reason for this may be the regulatory and supervisory restrictions necessary for the maintenance of financial stability and for the provision of a measure of protection to investors and depositors. Financial innovation may involve some form of regulatory arbitrage or operations beyond regulatory reach, possibly spurred on by a strong desire to economise on the use of the limited capital available to financial intermediaries, and therefore a tendency to devote less attention to information disclosure and risk management.
Also relevant is the indisputable truth that, at the systemic level, there is a conflict between the private interests of financial intermediaries in profit maximisation and making financial intermediation more efficient, which might reduce the net margin between investor return and the cost of funds for borrowers. Because of this, when financial intermediaries get involved in financial innovation, they may, in the longer term, become victims of their own success, although they may not realise it. Yet they are still keen to do so, at the level of individual firms, understandably attracted by short-term profits. But this may lead them, in their enthusiasm, to misunderstand or overlook the risks associated with their innovative initiatives, not to mention the risks to the stability of the financial system as a whole.
Therefore, as well as bringing benefits to investors, borrowers and financial intermediaries, financial innovation creates complex risks that may be beyond the capacity of market participants and the regulatory authorities to understand, let alone manage. Ironically, this could lead to significant disadvantages for the investors, borrowers and financial intermediaries who benefited from the innovation in the first place. Investors could find themselves holding assets whose risk-return profile turns out to be different from what they believed. Borrowers, having been encouraged to take on higher leverage to conduct their business, could face a sudden fall in the availability of credit and a sharp rise in the cost of funding as the market for the new financial products dries up in the face of investors' reassessment of the corresponding risks. The financial intermediaries could find themselves facing losses arising from risks they had taken unknowingly, for example having to re-assume risks that they thought they had transferred through innovative credit-risk transfer arrangements.
One important task of those responsible for the wellbeing of the global and national financial systems continues to be to harness the potential of financial innovation. The identification and management of risks associated with financial innovation, particularly those of a systemic nature, are crucial to financial stability and therefore the sustainability of economic expansion, on both the national and global levels. I am sure this will occupy much of the time of those involved in the months to come, although currently a lot of effort is still being spent in fire fighting. As a member of the Financial Stability Forum formed to address international issues like this after the Asian financial crisis, I look forward to continuing involvement in this important task.
Joseph Yam
28 February 2008
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