Title

Abstract

A sound financial system is one of the basic institutional prerequisites for generating rapid economic development. Furthermore, the pace of economic development is thought to depend critically on the rate of innovation in the economy. Financial innovation is central to economic growth and prosperity and that, consequently, financial system regulators should resist over-regulation that might thwart innovation. The paper discusses the benefits of financial system innovation and whether they are sufficient for regulators to avoid imposing restrictions financial institutions activities.

Introduction

A sound financial system is one of the basic institutional prerequisites for generating rapid economic development. Historically, this function has been performed by individuals or groups of individuals in the private sector as well as by financial institutions - be they government-owned or strictly privately owned. However, the introduction of such innovations in the real productive sector is typically not possible or efficient without a financial system that facilitates, stimulates, and promotes it.

Body

Securities markets fulfill the essential role of providing the necessary long-term equity capital to finance innovative activities. Similarly, banks provide the liquidity that maintains confidence and stability in the payments system and a strong payments system facilitates trade in commodities and in financial assets, ensuring that resources are allocated to the most productive and valuable sectors. Furthermore, the brokers, market makers, and dealers in financial markets need bank credit to maintain liquidity in the securities, while investors in the securities—individuals or institutions—may rely on bank credit to purchase securities.

Given these linkages, it is easy to see why development of a sound banking and financial system is a prerequisite for the development of financial innovations and why banks and securities markets play such a key role in anchoring economic development.

This strategic role of the banking and financial system was first emphasized by Schumpeter (1934), who considered credit creation as a monetary complement to the innovation process. Clearly, the ability of a country's financial system to play this strategic role depends on its capacity to introduce financial innovations - new financial instruments and markets, new decision processes and criteria, new organizational and managerial practices, and new institutions. These innovations may enhance investors' ability to reduce risk, and diffuse inevitable risk. This can be done by transferring risk to individuals and institutions as investors can differ significantly in their subjective perceptions of risk and in their ability to bear risk.

Recently, financial markets have expanded considerably with the proliferation of new financial instruments. These innovations have dramatically changed the financial landscape of the global economy and they enable economic agents to better manage their various portfolio risks. For example, a firm concerned about future interest rate fluctuations can simply and easily transfer this interest rate risk by dealing in futures contracts in the financial futures markets. In this instance, the market allows a firm to shift away its uncertainty risks and, in doing so, promotes a higher level of productive activity.

The scope of the explosion in these new financial securities and markets focuses additional attention on the question of how these financial ...