Financial Innovation and Financial Fragility

Abstract

The extent of structural change and product innovation in financial markets during the past twenty years has been striking. Regulatory and technological barriers inhibiting banking competition across state and national boundaries and between different types of financial intermediaries have tumbled, while new financial instruments and usages have proliferated. Moreover the pace of innovation has accelerated since 1980. Innovations of the 1970s such as currency futures, mortgagebacked securities and floating rate notes have gained much wider market acceptance in the last decade. Entirely new markets in financial options, currency and interest-rate swaps, zero coupon bonds and junk bonds have emerged since 1980 and already play a major role in portfolio management and in government and corporate finance.' Hyman Minsky alludes to this rapid institutional change in his recent treatise on financial instability, Stabilizing an Unstable Economy and notes the absence of any coherent analysis of its effects on the stability of the financial structure. In recent years we have seen many institutional changes in banking and finance. These changes have been permitted even though the authorities have no theory enabling them to determine whether the changes taking place in financial practises tend to increase or decrease the overall stability of the financial system.2 Minsky himself has no doubt that the overall impact of financial inno-