Question

Explain the role of financial innovation and the role of regulation in the generation of a
financial crisis.

Answer 1

Financial Crisis

The term financial crisis is well defined as sudden loss in financial sector due to mass withdraws from the banks, irrational behavior of investors in share market resulting share market to crash abnormally, and Increase in debt defaulters.

One of the major financial crisis was in 2007-08. It all began with "Lehman Brothers, the fourth largest investment bank" files bankruptcy followed by Merrill Lynch and AIG.

Financial Innovations: It is defined as the act of generating and implementing the new financial instruments for a smoother functioning of financial system/ mechanism.

Financial innovations lowers the cost of capital, promotes greater efficiency, and facilitates the smoothing of consumption and investment decisions with considerable benefits for house holds and corporations.

Financial innovations plays vital role in financial crisis. One of the major innovations is "Securitization", which eventually withdrew the risks from the institution's accounting balance sheets. It will also help to moderate business cycle fluctuations. Other innovations such as home equity loans and credit cards allow individuals to keep their consumption smooth even when their incomes are not met as per their needs. The increased availability of credit to business allows them smooth their spending across short duration when their revenues do not cover costs.

With a rapid change in technology, the financial sector has come up with many innovations such as ATMs (Automated Teller Machines), Digital Payment Wallets, Net Banking, Phone banking..

Financial innovations minimizes the cost of capital, promotes greater efficiency, and facilitates the smoothing of consumption and investment decisions with considerable benefits for households and corporations. As the new products contribute to the deepening of financial markets, innovation, in turn, fosters economic development.

Financial innovations may also moderate business cycle fluctuations.

Financial Regulations

Financial regulations are set of rules and laws that govern the financial sector. It provides stability to the financial system, consumer protection, fair competitions and also to prevent and reduce the financial crimes.

The global financial crisis seen in the past  led to reconsideration of the benefits and costs of open financial markets, leading to calls for reassessment of the global financial architecture.

Types of financial  Regulations:

There are various measures and combinations in place for the financial regulatory structure across the globe.

1. Supervision of Stock Exchanges

2. Supervision of Listed Companies

3. Supervision of Investment Management

4. Supervision of Banks and Financial Service Providers.