Navigating the Waves of Financial Innovation: Critically Reflect About the Impacts on Economic Organizations and the Role of Derivative Products in Crisis Escalation

Abstract

The essay explores the dynamics of financial innovation within the context of economic organizations and the global financial system. It delves into the historical development of financial innovations, their impact on organizations, and the reasons behind their emergence. The study particularly emphasizes the period between the 1980s and the 2008 global financial crisis, dissecting the adverse effects of financial innovations, such as derivative products, on economic stability. The essay underscores the role of technological advancements in shaping financial markets, leading to a diverse range of products and services. It critically examines the advantages and disadvantages of financial innovations, emphasizing the need for careful evaluation to minimize risks.

The narrative unfolds with a comprehensive overview of financial innovation, its definition, and historical roots, extending from ancient civilizations to modern times. The essay underscores the importance of organizations adapting to rapid changes in financial markets and the significance of effective leadership in navigating dynamic environments.

A significant portion of the essay focuses on the reasons behind financial innovations and their products. It discusses how market participants employ innovations to mitigate risks, and it evaluates the impact of contemporary international financial markets' structural shifts on the proliferation of financial instruments.

The study also delves into the repercussions of financial innovations during crises, particularly examining the 2008 global financial crisis. It highlights the complex nature of derivative products, their role in the crisis, and the subsequent challenges faced by national economies, organizations, and the global financial system. The essay concludes by emphasizing the need for a balanced approach to financial innovation, considering both its positive and negative consequences, to ensure sustainable economic growth and stability.

1.    Introduction

In financial markets, innovation refers to the adaptation of an existing idea rather than the creation of something entirely new. To qualify as a financial innovation, this idea must enhance market efficiency by improving transaction processes. Financial innovation refers to the development of new products or processes that exploit opportunities for profit due to the presence of incomplete financial markets and inefficient financial intermediaries.[1] Financial innovations are defined as the process of developing new financial technologies, financial instruments, institutions, or markets.[2] Also these developments are regarded as essential components of the economy.

Financial institutions create novel financial instruments to entice investors and cater to the segment seeking funds during periods of heightened economic instability, when traditional investment vehicles become less significant. Consequently, there is a growing significance placed on derivative products and novel instruments. Financial innovations, in this context, refer to components that mitigate risks and expenses while satisfying the demands of financial consumers through the provision of enhanced financial assets or services.[3]

The financial system's primary role is to aid economic development by efficiently allocating resources under risk, contingent on its functional efficiency. It is outlined essential conditions for functional efficiency; including an efficient payments system, specialized intermediary institutions for savings aggregation, risk management tools, and an information dissemination system ensuring fast and equitable access to price-related information.[4] The enduring relevance of these functions remains unchanged despite potential shifts in the financial system's institutional structure. True and lasting innovation, as seen with ATMs and derivative products, enhances the system's overall efficiency, simplifying tasks like payments and risk management.

The advantages of financial innovation, as highlighted by encompass cost-effectiveness, broad accessibility to significant user groups, risk hedging opportunities, flexible maturity structures, heightened liquidity, and expanded limits on financial resources.[5]

However, it is also recognised that financial innovations cause confusion and involve more risk than they appear to be, which are potential negative consequences of innovations.[6] In addition, credit-default swaps and collateralised debt obligations are said to cause very serious negative consequences.[7]

In this context, although financial innovations encourage individuals to save and invest and lead to positive economic outcomes, it is important to recognise that financial innovations do not only have positive consequences but may also lead to negative consequences. When the effects of financial innovations on banks are analysed, it is found that they increase bank fragility and profit variability, and countries with higher levels of financial innovation before the crisis suffered more from the crisis.[8] 

2.    Innovation Concept and History

2.1.        Definition of Innovation

The word innovation can be defined as differentiating in terms of scope, looking at a similar situation from a different perspective by putting forward new ideas and bringing beneficial solutions to problems by applying all these. Innovation can occur as an original idea, product or business strategy in itself, or it can be expressed as presenting an existing product or service in different ways.[9] In addition, innovation is also defined as a change that creates a new dimension in productivity.[10]

In the financial sector, innovation can be defined as a previously unused financial product or process that arises as a result of the inadequacy of existing financial instruments or the incomplete formation of markets.[11] However, innovation can also be considered as activities that focus on developing new financial instruments and services that reduce risk and cost.[12] There is no definition of financial innovation that is accepted by the majority in the literature and for this reason, it would be appropriate to adopt the definition according to the purpose.

2.2.        Historical Development of Financial Innovations

In 1840, with the invention of the telegraph and then the telephone, local and global fund transfers and information flow became possible. Both the telephone and the telegraph were widely used in the financial system in the following years.  As a result of these technological developments, the Federal Reserve Bank started to use the first electronic fund transfer (EFT) system in 1913.[13]

Although it is stated that financial innovation gained importance with the birth of modern capitalism, in fact, the historical development of financial innovations dates back to ancient times. Financial instruments used in Mesopotamian civilisations for the delivery of goods and services on credit, paper money used in China in the 9th century, deposit cheques and bond markets used in Venice, commodity exchange structures developed in the Netherlands in the 17th century are examples of these innovations; and after 1970, financial innovations emerged in parallel with these developments.[14]

3.    Reasons for Financial Innovation

The factors that cause financial innovations are the continuous fluctuations in interest rates, inflation and foreign exchange rates in the economy. The risk arising as a result of these fluctuations greatly affects the decisions of lending financial institutions and investors. Due to irregular increases in the inflation rate and continuous changes in interest and exchange rates, financial institutions have had to adapt both assets and liabilities in their balance sheets to their maturity structures. Financial market participants, grappling with inherent risks, turn to innovations to mitigate exposures.[15]

Contemporary international financial markets undergo structural shifts marked by the observation of financial innovations, securitization transforming loans into assets, transaction concentration in global centers, and the integration of markets into a unified global financial market.[16] These changes favor direct financing, relegating indirect financing, prompting banks to diversify products, discover novel financial instruments, and adopt innovative service pricing methods for sustainability, aligning with technological advancements. Therefore, the impetus for financial market innovation stems from economic, technological, and legal developments.[17]

4.    The Impact of Innovation on Organisations

As organisations operate within the economic order, they have to closely follow innovations in financial markets and financial products. Economic organisations are directly exposed to social, cultural, economic and physical changes in their environment. Responding to these changes effectively and ensuring the sustainability of the organisation requires anticipating the changes and taking the necessary measures. In this context, financial innovation is especially important in banking because banks can provide more benefits to their customers with increased financial innovations and get more benefits in return, thus achieving a better position in the competitive environment.[18]

Today, the rapid development of communication and information technologies with the effect of globalisation has increased the speed of change. It is thought that organisations that cannot keep up with this rapid change may lose their competitive advantage. Therefore, it is of critical importance that managers and employees of organisations effectively lead this dynamic change and take necessary measures. In case of failure of change, organisations may not be able to achieve their goals and may even cease to exist. In this context, it is of great importance for economic organisations to adapt quickly and effectively to change processes and to respond sensitively to innovations in financial markets. Therefore, continuous improvement and development programmes are implemented to achieve better results and create competitive advantage.[19] Otherwise, those that resist change may be disabled in this dynamic competitive environment and may have difficulty in sustaining their existence. If the change does not take place successfully, organisations cannot achieve their goals or the organisation may be destroyed.[20]

5.    Negative Consequences of Innovations

There are many advantages provided by financial innovations in the financial sector. Some of these advantages include fast finalisation of services, reduction in transaction costs, and offering alternative instruments and products. However, contrary to these advantages, the degree of risk, uncertainty and complexity created by new financial products and services has increased. In addition, it leads to increased competition among institutions, which in turn leads to the formation of new financial instruments, R&D studies and more funding allocations. Similarly, extra time and training costs have to be spent as financial education is required for employees in the financial sector to learn and adopt financial innovations. Another negative consequence of financial innovations is the decrease in the need for labour force and mechanisation in some business lines due to new systems provided by technological developments. Another disadvantage that we can mention at this point is that the definitions of money supply have changed as a result of innovations and it has become much more difficult to group the sub-items of money supply according to their liquidity. This is because, as a result of innovations, the amount of money held by individuals has decreased and this has led to a decrease in the demand for money. As a result, both money supply and money demand are difficult to forecast, leading to instability in the economy. In order to prevent these disadvantages, innovation processes should be well evaluated and the risks that may arise in the economy should be minimised. Moreover, since large institutions play a crucial role in the process of financial innovation, policy makers need to focus on large firms in particular and to regulate them in order to mitigate negative consequences.[21]

6.    The effects of Innovation on Global Crises

6.1.        Onset and Intensification of the 2008 Global Financial Crisis

The onset of the global financial crisis can be traced back to the second quarter of 2007, when the housing market began to decline.[22] The crisis further intensified in September 2008 with the collapse of Lehman Brothers, a prominent investment bank in the United States.[23] This crisis originating in the United States resulted in the financial turmoil of large institutions and the subsequent nationalisation or acquisition of some of them. During this period, prominent financial institutions such as Bear Stearns, Lehman Brothers, Merrill Lynch, and AIG experienced bankruptcy, while other significant banks like Washington Mutual and Wachovia were acquired. This financial collapse is widely regarded as the most significant crisis since the Economic Depression of 1929, causing a profound impact on the global economy.[24] 

6.2.        Role of Derivative Products in Crisis Escalation

Key factors contributing to the crisis include interest rate policy, distortions in the mortgage market, inadequate risk control measures, increased financial vulnerability, and speculative surges in housing prices leading to price bubbles.[25] Derivative products significantly contributed to the escalation of the crisis, while the absence of proper supervision and oversight caused their proliferation within the US economy and globally.

By expanding, the financial sector has both increased the variety of products and improved the techniques in the financial field, which made it possible to sell risk by dividing it into different components. The mortgage market in the US has reached a size of USD 10 trillion, making it the largest market in the world. In the beginning, mortgage loans were generally "prime mortgage" loans to high quality customers, but over time, as the customer portfolio expanded, the quality of the customer decreased and high-risk loans called "subprime mortgages" started to be given.[26]

In 2006, the volume of subprime mortgage loans in the US reached USD 1.3 trillion.[27] The Federal Bank’s interest rate hikes and the fall in housing prices caused low-income groups using these loans to experience problems in repayment.

In order for low-income individuals to own a house, subprime mortgage loans were allowed to increase and this led to the formation of an unsupervised structure. The uncontrolled growth of derivatives markets and inadequate regulation led to unrealistic speculative increases in housing prices and price bubbles.[28] Starting from the USA, a crisis environment emerged that affected many countries, especially European countries and Turkey.[29]

In 2008, payment problems were observed in prime, near prime and subprime loans. Moreover, the problem rate of floating rate loans was higher than fixed rate loans. After the demand boom in the first half of the decade, the US housing market entered a period of sharp contraction, with single-family housing construction permits falling and existing home sales declining.[30]

The 2007 and 2008 crises were characterised by a series of precursor crises that pointed to future crises. These crises, which accelerated and became more frequent since the 1980s, actually signalled a deep problem in the world economic system. The changes in the world political and economic balance in the 1970s, the collapse of the global money market with the Bretton Woods system and the failure to determine a new general rule created a crisis-prone environment in the international economic situation.[31] In this international environment, financial innovations are considered to be the main factor causing first regional and sectoral crises and then global crises.

The adverse impact of financial innovation, which emerged in the S&L crisis and then manifested itself in the 2007 crisis, has many commonalities, such as commodity prices, sudden volatility in interest rates, legal regulations of government agencies and their deliberately flexible implementation.

Financial institutions or banks called Savings & Loans can also be found in other countries, but they are mostly a US-specific type.[32] These organisations are known as "thrifts", a type of co-operative bank. These organisations, which were usually local, had legally directed their lending facilities largely towards home loans and, in order to avoid taking risks, they only lent to people they knew.

This collapse in the mid-1980s has been described as the biggest collapse of US financial institutions since the 1930s and continued its effects until the early 1990s.[33] While approximately 100 banks fail in the US every year, this crisis, which started in the real estate sector, which actually lends to the financial sector and led to the bankruptcy of banks in the US, should be considered as an important clue regarding the 2007 mortgage crisis.

7.    Conclusion

In conclusion, this essay has provided a comprehensive exploration of the dynamics of financial innovation, spanning from its historical roots to its impact on global crises.

Financial innovation, defined as the development of new financial technologies, instruments, institutions, or markets, has been an essential component of economic evolution. The historical background from ancient civilizations to modern times has witnessed the continuous adaptation and creation of financial products and processes to meet the evolving needs of economic organizations.

The reasons behind financial innovation are linked to economic fluctuations, such as changes in interest rates, inflation, and foreign exchange rates. As the global financial system undergoes structural shifts, marked by innovations like securitization and the integration of markets, financial institutions strive to mitigate risks and adapt to dynamic environments. However, the essay underscores that while financial innovations offer advantages such as cost-effectiveness, risk hedging opportunities, and heightened liquidity, they also bring about complexities and potential negative consequences.

The impact of financial innovation on organizations, particularly in the banking sector, is significant. Organizations must adapt to the rapid changes in financial markets to stay competitive. The role of effective leadership in navigating dynamic environments is emphasized, stressing the importance of continuous improvement and development programs.

Despite the advantages, the negative consequences of financial innovations, such as increased risk, complexity, and decreased demand for labor, should not be overlooked. The essay argues that thorough evaluation of innovation processes is crucial to minimize risks and prevent instability in the economy.

The examination of the 2008 global financial crisis reveals the role of derivative products in escalating the crisis. The unchecked growth of derivatives markets, inadequate regulation, and speculative increases in housing prices led to a crisis that affected not only the United States but also many countries globally. Financial innovations, which initially offered promise, played a pivotal role in triggering and intensifying the crisis.

In light of these findings, it needs for a balanced approach to financial innovation. While innovation is essential for economic growth, it is crucial to consider both its positive and negative consequences. Policymakers, especially in large institutions, are urged to focus on effective regulation to mitigate the potential negative impacts of financial innovations. Consequently, a carefully evaluated and regulated approach to financial innovation is essential for ensuring sustainable economic growth and stability in an ever-evolving global financial landscape.

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