Analysis of Financial Innovation: The Bright and Dark Sides by Beck, Chen, Song - Article Example

Article Summary Analysis: ‘Financial Innovation: The Bright and Dark Sides’ Student’s Name Institutional Affiliation Introduction The focus of the paper is to examine the hypotheses related to the bright and dark side of financial innovations. In doing so, it establishes and adopts a sample of 32 countries and evaluates their data for the period between 1996 and 2010. It is noted that the conventional perception of financial innovation ascertains of its brightest side so that it improves on the overall quality and variety of banking services; ensures that there is the concept of risk sharing; completes the existing market as well as ensures to improve on the overall allocative firm efficiencies (Beck et al, 2013). On the darker side, financial innovations is perceived to be the major contributory factor to that recently witnessed financial global crisis. During the crisis, financial innovation resulted to the unexpected credit expansion strategies that catapulted the progress of the boom and consequent bust in housing prices. The authors note that currently, there is little or no information related to finding the real and financial implications of financial innovations, which is mainly due to lack of substantive data within this area (Beck et al, 2013). Despite there being data evaluation on financial innovation on matters related to newer forms of financial securities; launching of credit scoring techniques and newer organisational forms like internet-only based banking, their conceptual studies have indeed resulted to a great level of mixed outcomes. DeYoung et al (2007) findings supports the hypothesis that there is stronger level of evidence which links financial innovation to an improved overall bank growth while also supports financial deepening. In regards to this research hypothesis, support is ascertained whenever it is established that US community banks that have gone ahead to adopt internet-banking have continued to witness a substantial level of profitability growth as a result of deposit-related charges. Notably, Berger et al (2005) argues that small and medium sized business credit scoring will always improve their respective amounts of bank lending at any given moment in time. Other research studies further indicate that the banking institutions, which utilises their credit derivatives as risk management strategy would most certainly transfer any level of benefit that accrues from the process to its immediate customers in form of lower interest spreads as well as cut lending in the event of a global financial crisis. In determining the how such financial innovation instruments as securitisation changes as well as ex-ante incentives of financial intermediaries is able to provide pertinent care to the borrowers, it is noted that there is a reduction in possible asymmetric information (Beck et al, 2013). It is important to understand that this asymmetric information has the capacity of improving the level of risk-taking as a result of probable existence of agency issues that can exist between bank owners and management or even lower expenses related to fragility of banks. Following this line of argument, the article adheres to the concept put forth by Tufano(2003) of financial innovation that is directly linked to invention and diffusion of newer products, services or even ideas while at the same time direct its attention to aspects related to R&D spending in the overall financial industry. To be specific, the paper conducts the analysis using the OECD innovation survey data on banks’ R&D expenditures for 32 countries for the period extending between 1996 and 2010 in order to establish possible wider indicators of financial innovation; financial system securitisation capacity as well as the overall importance of off-to on-balance-sheet assets like the patterns of innovation within particular sections of the sector as a whole. The paper seeks to relate the concept of financial innovation to variables related to bank growth and fragility within the aforementioned period as overall bank performance in the course of the recently witnessed financial crisis. By use of more than 2000 banking institutions’ data situated within the 32 countries, the paper establishes that higher degree of financial innovation is attributed to the aspect of high banking growth and fragility (Beck et al, 2016). In fact, to show evidence for this hypothesis, it is ascertained that the bank’s profitability significantly dropped at a higher rate in the course of the recently witnessed financial crisis while the financial concept related to buy-and-hold stock options returns were also lowly positioned within the countries that portrayed a high pre-crisis levels of financial innovation. It is also hypothesised and proven that a higher level of financial innovation adoption by the an underlying financial sector within any given country results to a stronger relationship between the country’s immediate wide variety of growth opportunities as well as gross domestic product per capital growth as well as a higher development of industries that enjoys greater growth opportunities (Beck et al, 2016). Background Literature In ascertaining the relationship that exists between financial innovation and bank performances poses an inquiry on how it affects the underlying financial sector. There is extensive set of literature in both finance and growth that indicates that there is indeed a positive correlation between aspects of financial development and economic growth as being rapid crisis indicators (King & Levine, 1993). Prior research also supports the presumption that financial innovation would technically improve overall bank growth and financial deepening. For instance, DeYoung et al (2007) establishes that Internet adoption was able to improve on US community financial institutions’ overall profitability levels especially due to efficiency in deposit-related charges. There are also studies that indicate that small business credit scores would technically result to an improved quantity of bank lending frameworks. In fact, CDS trading, according to Norden et al(2014) is able to improve on a bank’s credit supply as these institutions further adopts credit derivatives as viable risk management strategies. A counterfactual historic analysis indicates that there is appositive contribution made to financial deepening as well as economic growth of different financial innovations like venture capital; equity funds; mutual and exchange-traded funds and securitisation. Existing set of literature on financial innovation has been able to predict a higher degree of differences that exists for its immediate impacts in relation to its overall nature and the regulatory environment as well as the market setting for which financial innovation occurs and where it influences the banks incentives for purposes of risk-taking (Beck et al, 2016). According to Helpman (1993) most of the literature on the concept of innovation is majorly focused on manufacturing industry especially in regards to such components as patents, R&D expenditures as well as a share of research staff as being notable predictors of innovative activity. It is important to emphasise that since there has been no direct reviews made in regards to the concept of financial innovations, past researches have thus solely focused on distinct and specific forms of innovations like the new forms of financial securities; the introduction of credit scoring models; newer forms of mortgage lending as well as newer types of organisational structures like in the case of Internet-only banking institutions (DeYoung, 2001). Data and Model Estimation The data used for this study is collected from 2000 banks that are spread within 32 countries across the globe. Most of these countries are developed economically. The process of data collection is conducted in phases (Beck et al, 2016). First, data is collected that is based on R&D expenditures within the numerous financial intermediation industries from the Analytical Business Enterprise Research and Development Database (ANBERD). The source of this database is the OECD/Eurostat R&D surveys related to the 32 nations for the period between 1987 and 2009. It is crucial to note that the R&D expenditure data consists of both intramural and extramural expenditures on R&D (Beck et al, 2016). The analysis however resumes from 1996 since it forms the base period for which data of all sample countries is easily accessible and the data is integrated with that of OECD Science, Technology and R&D Statistics for possible missing data within the ANBERD database. To be specific, the study obtains banking sector data of 32 countries from SourceOECD Statistics, which is made up of 26 OECD and other 6 non-member countries (Beck et al, 2016). The study relies on Financial R&D Intensity (Value Added) as the main indicator of financial innovation. An alternative gauge of standard financial R&D by total operating cost of banks to come up with Financial R&D Intensity (Cost). Bank Scope provides data for missing values in some countries whereby an aggregate informational data is obtained related to the respective country and year (Beck et al, 2016). In establishing the effects of bank’s performance on overall economy, the study develops a model related to the securitisation capacity of a country where the sum-total of outstanding values of all securitised assets within the country that could include; asset-backed securities (ABS); collateralised debt obligations (CDO); mortgage-backed securities as well as enterprise-backed securities assets are all divided by the underlying GDP figure (Beck et al, 2016). In finding the relationship that exist between financial innovation and banking growth, the study adopts a regress bank growth model that is subjected to a set of different measures of financial innovation as well as another on bank and country-level control variables as shown with the formula below; In establishing the relationship between financial innovation and bank fragility, a similar regression as above is used however; a distinct measure of the bank’s immediate distance to default as a dependent variable is adopted as shown in the formula below; Findings A descriptive statistics indicate that the mean value of Financial R&D Intensity (Value Added) is 0.4% with a subsequent standard deviation of 0.56% (Beck et al, 2016). It is also found out that there is a cross and within-country variation time as can be expounded by the standard deviation of 0.42% as well as a lower standard deviation of 0.34%. It is determined that all of these values are indeed placed lowly however; they all conform to the averages of R&D intensity of 0.455% within a service sector but not the service sector. They are comparing to a 4.812% in the overall manufacturing sector across a similar sample of countries as well as duration (Beck et al, 2016). The innovation-growth hypothesis ascertains that there is a highly positioned bank growth level in those economies that enjoy a higher level of financial innovation; while the innovation-fragility hypothesis indicates that higher banking fragility in economies with higher levels of financial innovation and, also, lowly-positioned book and market-focused performances in the course of the recently witnessed financial crisis (Beck et al, 2016). Countries that indicate a high degree of Financial R&D Intensity (Value Added) witnessed a significant increase in overall asset-growth. These results posit a very informative information to policy seekers and especially economists who are now encouraged to come up with policies that favour introduction of different financial innovations to foster overall growth in GDP and financial asset-backed securities within any given period in time (Beck et al, 2016). Conclusion This article has successfully argued that the recently witnessed global crisis resulted to numerous debates related to establishing the both dark and brighter side of financial innovation. There has been intensive evidence that there exists a distinct level of innovation-growth, fragility and economically viable performances as a result of formulation and subjection of financial innovation instruments into bank performances. In fact, it has been noted that financial innovations have helped banks to increase their credit lending scores while at the same time enjoy risk management strategies as a result of adopting financial innovation. On the negative side though, the aspect of financial innovation has resulted to an unnecessary increase in bank’s overall profit volatility; fragilities and their immediate losses in the course of a possible banking crisis. Economic-wise, financial innovation has been shown to foster economic growth as it has assisted in exploitation of a substantial set of growth chances within a given financials sector of a country. References Beck, T, Chen, T, Lin, C & Song, F, M. (2016).Financial Innovation: The Bright and the Dark Sides. Journal of Banking and Finance, 72, 28-51 Beck, T et al. (2013). Bank competition and stability: Cross-country heterogeneity. Journal of Financial Intermediation, 22, 218-244 Berger, et al. (2005). Credit scoring and the availability, price, and risk of small business credit. Journal of Money, Credit, and Banking, 37(2), 191-222 DeYoung, R, et al. (2007). How the Internet affects output and performance at community banks? Journal of Banking & Finance, 31(4), 1033-1060 DeYoung, R. (2001). The financial Performance of pure play internet banks. Economic Perspectives Federal Reserve Bank of Chicago, 25(1) 60-75 Helman, E. (1993). Innovation, imitation and intellectual property rights. Econometrica, 61, 1247-1280 King, R, & Levine, R. (1993). Finance, entrepreneurship, and growth: Theory and Evidence, Journal of Monetary Economics, 32, 513-542 Norden, L et al (2014). Financial innovation and bank behaviour: Evidence from Credit markets, Journal of Economic Dynamics and Control, 43, 130-145 Tufano, P. (2003). Financial Innovation: the last 200 years and the next, In: Constantinides, George M, Harris, Milton, Stulz, Rene, M (Eds). The Handbook of the Economics of Finance, JAI Press Inc. Read More