Financial Innovation and Regulation

Abstract

Financial innovations have changed the world from the time man invented the concept of interest in Mesopotamia, paper money in china to the modern Debt or Equity based mutual funds. Financial innovations occur because market participants are constantly searching for new ways to make greater profits. Profit making is the fundamental dimension for an enterprise to sustain, perform and grow. The aim of financial innovation is to make different services offered by financial system cheaper and more available. With financial innovations market participants attempt to minimize risk and to maximize return. Financial innovation will lead to decrease the effectiveness of the monetary control. Financial innovation also makes it is much harder to interpret financial data as sensitivity of the data is likely to change as a result of financial innovation. The effects of the financial innovation on the structure and operation of the financial system are thus profound. Regulation and competition are the two basic drivers of financial innovation. Most financial innovation exploits inefficiencies created by regulation and governance mechanisms. Regulation should directly aim at the systemic containment of risks. Financial innovation may provide a short-term safety valve when politics and regulation become stalled or dysfunctional. The task of regulation should be to design a robust system while reintroducing the freedom to go bankrupt. Therefore, a radical change in the approach to financial regulation is needed.