Regulatory Issues Related To Financial Innovation

Financial innovations carry risk, some prove to be beneficial on net, but some others result in adverse outcomes. Authorities must ensure the infrastructure needed to support innovative activities in finance is in place and functioning properly.

Some financial developments have been efforts at liberalisation, which allowed for increased competition across sectors and borders. This has created the need for greater resilience. Financial innovations raise a number of policy issues, so it might be advised that innovations be treated on a case-by-case basis.

Banks often create entirely new products and trading strategies to deal with financial innovation. This can create a more optimal distribution of risks throughout the system so that risks are shifted to parties with the ability to bear them.

The evolution of financial services

There are periodic episodes of instability which tend to occur in the wake of innovations. Failures of discipline across all participants in the latest financial crisis was caused by insufficient concerns about credit risk, the mis-pricing of risk and complex policies that were not understood.

Measures needed to prepare the system for innovative activities

1. Despite periodic problems, innovations have generally been positive, on net, for economic growth and development. Authorities should not be predisposed against innovations.
2. Market framing rules alone are not sufficient. The challenge is link the structure to innovative activities.
3. A balance between regulation and supervision, competition and market pressure. Poorly designed regulation can distort market signals and result in net costs instead of benefits
4. More regulation may not be the answer to emerging problems. Begin with a clear idea of what is meant by the goal of systemic stability. This does not imply zero failures.
5. A too-big-to-fail doctrine may encourage excess risk taking that results in more serious problems once failures do occur. It must be possible for institutions to fail, even large ones. This requires a framework for the orderly unwinding of failed institutions.
6. Oversight needs to be expanded to address macro-prudential concerns, including securities markets and the interface between institutions and markets.
7. Establish a proper framework to ensure adequate protection for consumers to continue to attract capital and function efficiently.
8. Supervisors must have an in-depth understanding of the institutions including the particulars of risk management models and internal control structures.
9. Authorities need to ensure that institutions have the proper internal control mechanisms for the types of risks they assume, to moderate effects and prevent serious harm to consumers.
10. New products and processes should be analysed over time to see if amendments to regulations are needed.

Not all innovations are necessary for growth and development of the economy. Policy makers should not walk away and admit defeat, as innovations touch on issues that are of considerable public interest.

Regulatory measures should balance preserving safety and soundness of the system whilst allowing financial institutions and markets to perform their intended risk management functions. This requires a proper structure for reviewing financial innovations. The first step in the process is surveillance, then careful analysis before allowing a product to continue unchanged. A given product or activity may not raise particular concerns for some objectives, but may be a serious issue for others. All objectives must be considered and some authority must take a system-wide view.