Financial Innovation and Regulation

Financial innovation has been a defining feature of the financial sector over the past millennia, even though it is hard to define and even harder to measure. Financial innovation refers to new products (e.g., new types of securities), new technologies (e.g., credit scoring or ATM), and new institutions (e.g., venture capitalists or mutual funds). Recent intermediation forms, such as peer-to-peer lending and crowdfunding, also fall under the category of financial innovation. Goetzmann and Rouwenhorst (2005) identify 19 major financial innovations, grouped into innovations that (i) facilitate the transfer of value through time (e.g., savings accounts), (ii) enhance the ability to contract on future values (e.g., venture capitalists), and (iii) increase the negotiability of contracts (e.g., securitization). While some see it as critical input into the financial deepening process, others see it as core for financial fragility. In the following, I will argue that it can be both and that responsible and responsive regulation is critical to harness the benefits from financial innovation while reducing its fragility risks…