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What is Financial Innovation?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 30 November 2016
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Financial innovation is a broad term that is used to describe the generation of new and creative approaches to different financial circumstances. The term is sometimes used in relation to the creation of new types of securities. At other times, it has to do with new and interesting approaches to money management or investing. In any situation, financial innovation is all about offering an idea or financial instrument that is different from what has gone before, and has the potential to be extremely desirable in the long run.

There are a number of different theories regarding the basic nature of financial innovation. One approach, known as the Modigliani-Miller theorem, holds that investors should be very concerned about regulatory practices and taxation, and how those factors impact the types of securities that are issued by different entities. The investor should remain relatively unconcerned about any liabilities currently held by the issuing entity.

A different approach to financial innovation is known as the Arrow-Debreu model. This approach takes into consideration a number of external factors, such as political upheavals or natural disasters, and their subsequent impact on various types of financial instruments and the institutions that issue those instruments. The idea is to purchase those securities that will be favorably influenced by these world events, and thus maximize the return.

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In the broadest sense, financial innovation is something that takes place on a continuing basis. A number of innovative financial strategies and instruments have come into being since the decade of the 1980s. One example is the creation of interest rate swaps in the early years of that decade, an innovation that allowed many companies and investors to take advantage of the dramatic increase in interest rates that was taking place. In recent years, the development of the credit default swap also allowed businesses to more effectively manage the increasing number of defaults on loans, mortgages, and other forms of credit that took place as the world economy entered into a period of recession.

While many people do recognize the concept of financial innovation, there is no solid agreement of what constitutes a truly new approach, and what is simply a combination of a couple of older approaches that are given a slightly different configuration. The credit default swap of the early 2000s is a prime example, since some would say it is simply the older interest rate swap concept retooled to address a different economic situation.

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David09
Post 3

@miriam98 - Whatever the innovation, the money lender always stands to get the better end of the deal. I remember when I approached my dad about ideas for retirement income.

I asked him if he had ever considered a reverse mortgage.

I added that it was a new idea the banks came up with. He wryly replied, if the banks came up with it, he didn’t want any part of it.

I don’t quite share his skepticism. I’ve used innovative bank products myself, including a bridge loan that I took out to buy a new house before selling my current house. It was risky, but it worked; my house sold quickly and I repaid the bridge loan, with interest of course.

The point is you just need to weigh what both parties stand to gain, and weigh the options or find a better deal elsewhere.

miriam98
Post 2

@MrMoody - Financial markets and institutions make it their business to offer new products and services, and I do think they understand the products themselves. However, risk is the nature of any financial investment; and that risk is inherent whether the investor is an institution or a single individual.

One thing that should be pointed out, however, is that the money managers follow the gyrations of the market on a full-time basis, and so I do think they are better positioned to make the right calls most of the time.

The rest of us just follow hot tips we get from investment newsletters or investment shows on television. I say that you should perform due diligence, look for a good money manager with a proven track record, and leave the hard work to them.

MrMoody
Post 1

I am wary of some kinds of financial innovation. The whole derivatives market was a new financial strategy but it was incredibly risky and the majority of investors had no idea how these financial instruments worked.

Personally, I think there is a fine line sometimes between investing and gambling. I would place options and futures very close to the gambling category, if you don’t understand how they work. Only a few money managers do in my opinion; the rest are just following the herd.

Some people are predicting a major collapse in the derivatives market. I don’t think I’m smart enough to make a prediction like that. I just offer a simple piece of advice for financial risk management, regardless of the investment itself. If you don’t understand it, don’t invest in it.

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