GS Economy Hot Topic – 8

Financial Innovation ?

Financial innovation means when you come up with complex financial instruments other than prevailing ones; like (bonds, securities etc).  For Example, in 1980s there was simple thing :just one LIC life insurance policy. you pay installments, you die your family gets money. Now there are complex ULIPs (Unit linked insurance planning), child education plans, pension fund, travel insurance, health insurance. =financial innovation.

examples of financial innovations could be

  • interest rate swaps ,
  • credit default swaps,
  • Collateral debt obligation.
  • credit and
  • debit cards and
  • online payment systems like PayPal.
  • Advantages
  1. Makes life easy, e.g. Paypal, credit card, travel insurance etc.
  2. Helps you hedge the risk. Hedge= a fence or compound wall built to protect your property. Hedging = a method of preventing risk. Example, Oil Hedging

Main  Criticism 

a. fool’s paradise

There is no “neutral evidence that financial innovation has led to economic growth.”
example The money gone into bonds and policy should lead to real asset/physical product creation (like you buy insurance policy from me, and I lend that money to a businessman who makes a factory or launches a new physical product like cola or breads or a service like Hospital/ Hotel chain and so on… ) Then we can say yes this financial innovation is leading to economic growth.
But instead Some of the money goes into two directions

#1: further speculation business like mutual funds, commodity market or share market

(click me to first understand the Derivatives)
Like you buy some insurance policy/mutual fund/complex security bond from me, I invest that money in speculation, whether xyz share/commodity’s price will go up or not. (via options and futures contract) So I’ve a virtual portfolio : today 5 lakh, tomorrow 1 lakh third day not even worth 10,000, fourth day jumping to 10 lakh rupees. I’m betting and speculating, like those kids playing and trading WWF wrestler’s cards. No real asset creation or economic growth. In the meantime, you claim your policy, If my portfolio is 10 lakh, I would pay away otherwise I would borrow from third party to pay you and give that third party a futures bonds, he sells it to forth guy as a derivative who again invests it into some speculation game. This game goes on, without any real economic growth. Just more papers and bonds.

#2: The Complex financial products=Chor bank robbing you in daylight

Similarly you open a bank account in that Chor party bank (Chor=thief, you know which bank I’m talking about), they trick you into getting a credit card and deduct insurance premium behind your back saying that credit card comes with a ‘free’ health-insurance policy. And adding insult to the injury, when you get heart-attack, they don’t pay you, saying sorry heart attack is not covered, this health insurance covers minor injuries in road-accidents only* (*provided that you were wearing helmet/seatbelt, driver had licence and was driving under speed limit)! And whatever money the Chor party bank earns from this unethical game, they reinvest it into putting more ‘feel-good’ advertizements on TV to trick more people like you, while the already fooled customers get redirected like footballs from this call centre to that call centre. = No economic growth.

So, end product of this kind of financial innovation is a new even complex financial product – not a physical product or service that you can see/touch/feel or consume.

b. Led to recession

This innovation led to complex Derivatives that led to *asset bubble and ultimately we got recession.

Courtesy :MRUNAL

%d bloggers like this: