Edited by Luisa Anderloni, David T. Llewellyn and Reinhard H. Schmidt
Chapter 1: Financial Innovation and the Economics of Banking and the Financial System
1. Financial innovation and the economics of banking and the ﬁnancial system David T. Llewellyn Derivatives are ﬁnancial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal to the ﬁnancial system. (Warren Buﬀett, Financial Times, 4 March 2003, p. 16) If risk is properly dispersed, shocks to the overall economic system will be better absorbed and less likely to . . . threaten ﬁnancial stability. (Greenspan, 2002, p. 6) Not everything that counts can be counted, and not everything that can be counted counts. (Albert Einstein, 1936, sign in Einstein’s oﬃce, Princeton University) 1 THE CONTEXT In many respects, ﬁnancial innovation has become a deﬁning characteristic of national ﬁnancial systems. Two particular characteristics of the recent evolution of ﬁnancial systems have been increased globalisation of ﬁnancial markets, and the rapid growth of ﬁnancial innovation, and in particular the development of structured instruments and credit derivatives. One of the features of the globalisation of ﬁnancial markets is that ﬁnancial innovation generated in one market can be easily and quickly transferred to others. Notwithstanding recent interest in the topic, ﬁnancial innovation is not a new phenomenon. What is new is the acceleration since the mid1990s in the pace and range of ﬁnancial innovation, and the emergence of several secondary markets in which new instruments are traded, and the emergence of credit derivatives that enable credit risk to be shifted and traded (see Partnoy and Skeel, 2007, for a survey). In most developed 1 2 Financial innovation in retail...
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