Since the beginning of the 1970s and 1980s, financial markets have been marked by financial innovation.
The financial innovation is both the cause and consequence of three major structural changes: the development of quantitative economics and management of balance sheets, the rise of new information technologies and communications and liberalization ( or deregulation) of the economy.
Financial innovation has been marked in particular by the development of project financing techniques , asset financing, leveraged financing ( LBO ), structured financing, balance sheet management techniques (management of liabilities with the defeasance and management of assets with securitizations ), the portfolio management techniques and derivatives
The main objective of financial innovation has been to facilitate the development of credit, in particular through credit markets. It transformed the nature of capital, created “quasi-equity” and in fact sought to erase the difference between the various forms of capital inflows. It has consequently transformed the notion of property.
Financial innovation was supposed to reduce risk, but there have been many financial crises over the past two decades. This was the case for example in 1987, the Asian crisis, the subprime crisis. The last thirty years have also been punctuated by the creation and explosion of successive bubbles.
At the heart of financial innovation is the development through financial engineering of derivative products and in particular of credit derivatives. Derivatives markets have experienced very strong growth in recent years, both quantitatively and qualitatively.
Financial innovation has developed on the basis of the use of actuarial techniques and legal and financial engineering. It developed by taking advantage of banking deregulation.
The arrangements call for the use of legal, contractual and corporate arrangements, accounting creativity, and statistical analysis techniques for risk calculations in the context of financial market modeling.
The debate on financial innovation
Financial innovation benefits from the dogmatic belief in the advantages of modernity.
The argument has prevailed that these innovations would facilitate the allocation of risks between economic agents, and that risk sharing would improve the functioning of the financial system.
This risk management would allow the financing of high yield projects, which are also risky projects, and allowing investors to better manage their portfolio of assets.
In addition to risk-sharing, which operates more easily, financial innovations would theoretically contribute to market efficiency. This requires a reduction in transaction costs, better market liquidity, and incentives for the collection and dissemination of information.
The debate on financial innovations joins that of the virtues and dangers of speculation. For classical economists, speculators have a stabilizing effect on the markets: by buying securities when market prices are low and selling when they are high, they attenuate extreme variations. This view assumes, however, that agents adopt medium-term or even long-term strategies while asset prices return to their fundamental value.
Financial innovation used quantitative economics analyzes, modeling techniques and mathematical formulas to claim that the products it was developing were not speculative in nature and that they reduced risk.
However, in practice, the assumptions of the economy which had come to claim to be an exact science were a gross simplification of the functioning of the markets. Investors tend to base their decisions on the behavior of their peers rather than on the study of fundamentals. This also assumes that there are no obstacles to arbitrage operations, which is far from being verified.
Theoretically, the consequences of financial innovations on market volatility actually depend on assumptions about financial imperfections. In general, the effect induced by the introduction of new financial products is only favorable if it favors the participation of informed investors.
The increase in speculation via the futures markets has a destabilizing effect when certain agents have imperfect information; the other agents then overreact to what they believe to be inside information, which has a destabilizing effect. Derivatives are marked by information asymmetries.
Financial innovation and responsibility
Financial innovation gave birth to what have been called financial products .
This qualification, of “product” for contracts and securities, fits into the characterization of the development of new markets, and in particular of “derivative markets”, clearly responds to the desire to benefit from a great deal of freedom under the market economy “and to justify the absence of regulation, or the adoption of legal and accounting standards consecrating these innovations.
Product qualification is also part of the presentation of economics as an exact science, the use of models, mathematical formulas and the use of software to give a scientific image, with “‘products” resulting from the development of “financial techniques”. This qualification can expose banks and various stakeholders in this activity of “financial production” to a liability based on product liability, the inherent obligation of security. and information obligations.
It turned out that a very large part of these products were “toxic products”, that the assertions concerning the level of risk were inaccurate. Claims about protection techniques, such as single-line insurance, were misleading, as were claims about the level of risk provided by rating agencies. Savers and investors were harmed. Liability can be not only civil, but also criminal.