Financial Innovation & Risk

By Don Alexander, MBA
Associate, RSD Solutions Inc.
Mr. Alexander also lectures at NYU and SunySB

Since the start of the financial crisis, the debate about financial innovation has increased among economists and investors that warned that financial innovation has a dark side.  A number of new financial products have dramatically increased in complexity, but were poorly understood in terms of their risk characteristics.

A recent VOXEU communique by Thorsten Beck et al called Financial Innovation: the good and bad (T. Beck, T. Chen, C. Li &, F. Song, VOXEU, 2nd Oct.) looks at cross-country data on financial innovation and its positive and negative impact.  Their research on financial innovation provides evidence that financial innovation can lead to more volatility, more fragility, and more severe losses. But it also finds evidence of improved growth opportunities, better financing alternatives and increased R&D expenditure.

The traditional innovation-growth view posits that financial innovations help reduce agency costs, facilitate risk sharing, complete the market, and ultimately improve allocative efficiency and stimulates economic growth. The innovation-fragility view, on the other hand, focuses on the ‘dark’ side and has identified financial innovations as the root cause of the recent Global Crisis that resulted in a misallocation of resources, leading to an unprecedented credit expansion and a housing price bubble.  Financial institutions, by engineering securities perceived to be safe, exposed investors to excessive risks and misallocation of capital in financial markets.

The authors look at the impact of financial innovation on the real economy, specifically growth and volatility, as well as on the financial sector, through banks’ risk-taking and fragility.  The study uses a cross-country indicator of financial innovation and is applied to an array of real and financial sector outcomes.

The study produced the following positive results: countries where financial institutions spend more on financial innovation saw increased per capita GDP growth, and industries that rely external finance and R&D activity grow faster in countries where institutions implement financial innovation.

However, it also produced negative results: industries that rely external finance and R&D activity also experience more volatile growth in countries with high financial innovation, these countries are more fragile possibly due to a higher share of non-traditional intermediation activities and may experience higher bank profit volatility of banks with higher innovation. These results provide evidence for both the innovation-growth and innovation-fragility hypotheses.

It is important to note that the study’s indicator of financial innovation is focused on the process rather than on specific outputs of financial innovation, which can take many forms, such as new securities or products, new screening, monitoring and risk management tools or new types of institutions and markets.

Financial innovation can be associated with higher levels of economic growth and suggest that it is not so much the level of financial development, but rather innovative activity of financial intermediaries, that may help countries grow faster at high levels of income.  The results provide a direct link to the recent boom and bust experience in the early 21st century. The findings show that financial innovation provides significant benefits for the real economy but also contains risks that have to be managed carefully.

The lesson for the risk manager is they have to understand how financial innovation is measured, how the process works and not just look at the final product.

www.voxeu.org/article/financial-innovation-good-and-bad