Edited by James R. Barth, Chen Lin and Clas Wihlborg
Chapter 22: Financial Innovations, Marketability and Stability in Banking
Arnoud W.A. Boot and Matej Marinč 22.1 INTRODUCTION Having well-functioning financial institutions and markets is considered important for the economy at large. In this context it is important to look at the proliferation of financial innovations and ask what this has done to the functioning of the financial sector. When looking at the last few years with the financial crisis at the center of our attention, one is tempted to conclude that recent innovations like subprime mortgages and their repackaging in marketable securities have not contributed to the well functioning of the financial sector. But this conclusion might be premature. The key question addressed in this chapter is therefore how financial innovations have affected the structure and stability of the financial services industry. A fundamental feature of recent financial innovations is that they are often aimed at augmenting marketability; see for example securitization and related products like credit default swaps (CDSs) and collateralized debt obligations (CDOs). Such marketability can augment diversification opportunities, yet as we will argue can also create instability. This is the focus of the chapter. We will argue that understanding the added value (and the downside) of financial innovations is important to understand the type of measures that might have to be taken. The point of view that we will advocate is that financial innovations have distinct value – and as such should be applauded – yet the institutional environment should be amended to control the negative effects that particularly the enhanced marketability might have induced. Facilitating marketability is...
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