Financial Innovation Essay Example | Topics and Well Written Essays - 1250 words

Financial Innovation - Essay Example Evidence adduced in this paper illustrates various instances of financial innovations that exempted regulation. The consequence has been economic crisis. Introduction The performance of the financial sector is crucial to the economy of the country. Innovation in the financial sector can contribute to the growth or destruction of the economy. The economic growth over the past few centuries demonstrate that effective approach to financial innovation could create prosperity of the nations. However, the issue of financial innovation has drawn criticism from some economists who believe that frequent economic crises experienced in the recent years are due to financial innovation. This paper seeks to debate the question should the potential benefits of financial system innovation deter regulators from imposing restrictions on the activities of financial institutions. Financial regulations serve to regulate the activities of financial institutions against plunging the financial market into c haos. For instance, the Federal Reserve requirement dictates the base lending rate that a financial institution should observe when lending in the public. However, it is evident through the recent financial crisis that financial innovation that led to deregulation exposed the economy to erosion. Economists have observed that banks and other financial institutions in the money market are in constant competition (Anderloni 56). This competition influences the practices that a financial institution would employ in conducting its business. Thus, financial institution practices must observe a given limit in innovation. For instance, studies on the cause of great depression have indicated that financial innovation practices subjected the economy to high-risk behavior whose consequence was the great depression (Calomiris 6). Critics to financial innovation have argued that benefits of financial innovation have failed to yield the anticipated growth because of the risk factors, which the in novation creates in the financial sector (Meessen 199). Most financial innovation leads to excessive risk taking or failure of the financial institutions to predict the financial behavior in the future. For instance, speculation by financial institutions prior to the 2007 US economic crisis led to high risk lending by most financial institutions leading to the collapse of many institutions because of credit defaults. Innovation practices are beneficial to the growth of the economy when the operations are within some control. The Federal Reserve Act 1913 sought to cushion banks from risking foreclosure during financial constraints (Anderloni 156). The idea behind the Federal Reserve is to promote practices that promote the interest of the society. The Commission Inquiry on Financial Crisis report indicated that lack of transparent practice among banks led to unscrupulous lending in the subprime mortgage leading to the financial crisis (A.C.S.1). Lending laws set some base lending whi ch protect the interest of the investors. For instance, the Volcker Rule influenced the banking practices by influencing the operation of the financial institutions within a ring fence. The rule defined the operation of the banks within national and foreign category. The category of these financial institutions enables a given banks within the ring fence to operate a particular financial activities (Calomiris 3). On the contrary, failure to categorize the banks within particular operating spheres exposed the public to risks because large financial institutions collapsed with investment of the majority of the public. Financial innovation should be subject to regulation because some of the innovation practices or proposals fail to reflect the real effects that they would