The financial sector performs two main functions: (1) reducing information and transaction costs, and (2) facilitating the trading, diversification, and management of risk. Financial innovation ensures that the financial system can provide these functions more efficiently. Financial innovation is the act of creating and then popularising new financial instruments, as well as new financial technologies, institutions, and markets. As such, financial innovation can play an important role in fostering growth and economic prosperity. At the same time, financial innovations have been blamed for their role in the recent financial crisis. This chapter discusses the causes and consequences of financial innovation.
Two important drivers of fi nancial innovation are regulation and deregulation, and technological advances. Regulation may forbid or otherwise restrain fi nancial innovation so that deregulation may spur innovation. At the same time, several innovations have been the results of attempts to circumvent regulation. Technological advances made new instruments possible. The credit card is a good example of financial innovation driven by technological advance, including improvements in communications, data management, and credit scoring.
Financial innovations may improve payments, offer new savings and investment opportunities, and may increase risk sharing. The first part of this chapter examines the causes and consequences of financial innovation, while the second part analyses the pros and cons of financial innovation. This chapter also zooms in on the risks of financial innovation by offering two case studies. One of these case studies is about securitisation of subprime mortgages. Credit rating agencies (CRAs) play an important role in securitisations. The final part of this chapter therefore explains the recent debate about CRAs and outlines the recently introduced regulation of CRAs in Europe.