Article Detail

Financial Innovation and Transparency in Turbulent Times

Journal 33: Technical Finance

Panagiotis Delimatsis

The stunning failure of a number of banks during the recent crisis has put regulatory intervention high on the agenda of governments. Adequate risk monitoring, including by credit rating agencies, measurement, and management have proven to be a daunting task, whereas regulation of innovative financial instruments has not brought about adequate disclosure and transparency. After critically reviewing the virtues and pitfalls of financial innovation, this paper offers an analysis of the main transparency initiatives undertaken in the E.U. and the U.S. in the wake of the crisis to harness various financial innovations that have marked the history of financial markets in the last three decades. The paper argues for better managed regulatory cooperation at the international level and warns against institutional deficiencies of the new regulatory frameworks in the E.U. and the U.S. One key message of the paper is that more regulation may hamper financial innovation; yet better regulation may direct entrepreneurial talents to financial innovations that enhance societal wellbeing and still yield reasonable returns.

The global financial crisis of 2007-09 has raised serious doubts about the correctness of the deregulatory practices of three decades of neoliberal orthodoxy in the banking sector, mostly hailed by developed countries for their adequacy. Doubtful securitization practices associated with the housing market and poorly regulated intermediaries were allowed to operate on the edges of the financial system. Complex financial organizations failed to properly obtain, process, transmit, and implement important information pertaining to imminent risk. Ultimately, the freezing of the inter-bank loan market, lack of suitable disclosure (and monitoring or evaluation thereof) in times of market euphoria and uncertainties about the well-being of the balance sheets of several banks (that the oligopolylike group of the U.S.-based credit rating agencies did not manage to capture in time) led to uncontrolled (but simultaneous and massive) sales of assets. In addition, the supervision frameworks in place failed not only to prevent but also to manage adequately the crisis and prevent it from spreading beyond the U.S. By stubbornly focusing on national supervision, such systems proved incapable of grasping the interconnections that exist today between financial markets and institutions. Overall, the crisis brought to the fore the pressing shortcomings that the current model of cooperation, coordination, consistency, and level of (mis)trust between national supervisors exhibits.

Financial innovation: past, present, future
The innate virtues of financial innovation
Financial markets have grown mainly due to important advances in information technology which allowed for cross-border supply of financial services. Consolidation through mergers and acquisitions, particularly in the banking sector, and the creation of “national champions” in several countries have also given a boost to cross-border trade in financial services. In Europe, significant cross-border consolidation has taken place, driven by several political initiatives to complete the single market for financial services at the E.U. level. Here again, the objective was to fully reap the advantages that innovative financial products offered to consumption. All these developments increased the interdependence, convergence, and consolidation in the sector and have altered the risk profile of financial institutions.

Financial innovation is an ongoing, dynamic process that entails the creation and subsequent popularization of new financial instruments, as well as new financial technologies, institutions, and markets. It appears to be driven by investor demand for particular patterns of cash flows. Financial innovation experienced steady growth in recent years and arguably transformed the once relationship-based financial intermediaries. Financial innovation is very much linked to globalization. In fact, it is one of its drivers. Financial innovations of technical nature have facilitated the splitting up of several financial activities, leading to the emergence of the global phenomenon of outsourcing. Processing and management of client data, research, or clearing and settlement of payments can be supplied nowadays in the four corners of the globe in a very streamlined and expedited manner. If one considers globalization as an irreversible process, which appears a reasonable assumption, then financial innovation will continue to play a central role in the aftermath of the crisis.

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