Financial Innovation: An Essential Part of the Innovation Process

It may not seem like an important enough topic and certainly one that some would say has questionable relevance to the more clear cut areas of innovation (technology, processes, managerial, to name a few), but I would argue that Financial Innovation should be at least on the radar screen of every policy maker charged with the responsibility of understanding and then administering public policy decisions. For Financial Innovation – the creation of products and services designed for use in the financial markets and real economy – has the power to alter an essential lifeblood of the global economy: the capital raising function of the financial markets.

To the degree that companies seeking to access the capital markets are enhanced or impaired has a direct impact on their ability to manage their existing capital and contemplate their future capital. And herein lies the issue of most direct relevance. For, if a company’s ability to fund its present and future operations is impacted (e.g. through a higher cost of capital) due to the fact that investor confidence has declined, then all other facets of innovation are impacted.

It is in this regard that Financial Innovation has contributed to a dramatically changed financial markets' structure, particularly over the past several decades. And in the process has coincided with a large-scale exodus of individual investors from direct equity ownership and concurrent rise and dominance of institutional investors in the financial market place. Yet, knowledge of how and why institutional investors do what they do is quite limited and often restricted to the domain of the more academically minded.

In my view, this is a mistake.

To begin, institutional investors are not a homogeneous group. They are diverse in methodologies and operations. Moreover, their client bases and motivations are far more varied than is generally acknowledged by the financial media, the average individual (non-professional) investors, many lower tier professional investors (e.g. financial advisors, wealth managers, stock brokers, and the like), and, importantly, public policy decision makers.

To drive home this point, consider that many have labeled today’s financial markets a casino: an environment where bets are made rooted not in a longer-term time horizon and based on financial modeling derived from academic attempts at explaining the social sciences of economic and finance but in nanoseconds based on algorithms, hot money flows, and themes of the moment. Such a set of circumstances has brought about the rise of a risk on (buy stocks)/risk off (sell stocks) mentality.

To the extent that what happens in the casino stays in the casino is an argument in favor of the current environment. However, market actions do not stay within the confines of the casino. Rather, through feedback loops to the real economy (what famed investor and speculator George Soros calls “reflexivity”) impacts to the real economy are felt – often in dramatic and sometimes pain inducing fashion. Moreover, when such an environment leads to a loss of confidence in the game itself by non-professional individual investors, then not just investing habits and a willingness to fund the capital raising function via new and secondary public offerings are effected but the knock-on effects to real economy activities occur as these very same non-professional individual investors are consumers - and consumers who see their personal net worth roiled by market actions that are incomprehensible can easily become reluctant to consume.

In sum: To understand Financial Innovation is to understand the nature of this changed financial markets' structure, which is to help understand the real economy impacts to innovation in general. This is what I will write about in future blog postings.