Financial innovation: The bright and the dark sides

The Global Financial Crisis (2007-2009) has renewed debate on the ‘bright’ and ‘dark’ sides of financial innovation. The ‘bright’ innovation-growth side argue that financial innovations help reduce agency costs, facilitate risk sharing, improve allocative efficiency and create economic growth. The ‘dark’ or innovation-fragility view has identified financial innovations as the root cause of the recent Global Financial Crisis, creating an unprecedented credit expansion fuelling a boom-bust cycle in house prices, engineering securities perceived to be safe but exposed to neglected risks and by helping banks and investment banks design structured products to exploit investor ignorance of financial markets and exploiting regulatory arbitrage possibilities.

Measuring financial innovation

There is a lack of data on financial innovation due to the absence of data in the financial sector relating to research and development expenditures and research staff. Using retrospective research and development data from business enterprise agencies, it is possible to standardize financial research and development with total operating cost of banks.

The indicator of financial innovation here is focused on the process rather than on specific outputs of financial innovation such as new securities or products, monitoring and risk management tools or new types of institutions and markets.

Financial innovation across countries is small, with the average value of financial research and development being 0.33 percent of value added, much smaller than the average of 2.11 percent in manufacturing. Financial innovation is high in Denmark and South Africa, but almost zero in Russia. Financial innovation almost doubled between 1996 and 2006, consistent with anecdotal evidence on increasing innovative activity within the banking system for this period.

The effects of financial innovation

1. Countries where financial institutions spend more on financial innovation are better able to translate growth opportunities into GDP per capita growth.
2. Industries that rely more on external finance and more on research and development activity grow faster in countries where financial institutions spend more on financial innovation. The dark side to this, is that growth is more volatile.
3. In countries where banks spend more on financial innovation, banks are also more fragile. This relationship is especially strong for banks with smaller market shares, faster asset growth and higher shares of non-traditional intermediation activities. This higher fragility is due to higher profit volatility of banks in countries with higher levels of financial innovation.
4. In countries where banks spent more on financial innovation before the crisis, they suffered greater reductions in their profits, relative to both total assets and equity.

Conclusion

Taking together with the traditional measure of Private Credit to GDP for each country the results provide evidence for both the innovation-growth and innovation-fragility hypotheses.

There is some non-linearity in the finance-growth relationship with declining, insignificant or even negative associations of finance with economic growth at high levels of GDP per capita.

Financial innovation in high-income countries is associated with higher levels of economic growth, even when controlling for aggregate indicators of financial development. This suggests that it is the innovative activity of financial intermediaries that helps countries grow faster at high levels of income, more than the level of financial innovation.

The double-sided nature to financial innovation, bringing opportunities but containing risks, requires appropriate and robust regulatory policies.