Financial Innovation: What Have We Learnt?

Abstract

In this paper, Nigel Jenkinson, Adrian Penalver and Nicholas Vause discuss what has been learnt since the start of the financial crisis about the limitations of innovative financial instruments. Financial engineering can help decompose, transfer and pool risks to match the risk appetite of lenders and improve the options available for households and companies to manage risk. But the paper argues that market frictions and imperfections can limit the effectiveness of financial innovation. Information is lost when there are chains of parties involved in credit creation. The ability to sell on or pool credit risk can reduce incentives to screen and monitor borrowers. Products with tailored risk profiles can be difficult to sell. The paper argues that these frictions have become more apparent since the onset of the credit crisis. The paper concludes that removing these frictions, for example through better credit screening, will be costly. Innovative financial instruments will also require a higher liquidity premium. Recognising these costs, though, will strengthen the resilience of the financial system and underpin the durability of the benefits of financial innovation.