Future Trend of Financial Innovation

1. Future Trend of Financial Innovation 周行一 Edward H. Chow 國立政治大學財務管理學系所教授 Professor of Finance 商學院 院長 Dean of College of Commerce 2008/5

2. Outline • Definition of innovation • Functional taxonomy of financial innovation • Financial innovation originates from market imperfections • A local financial innovation • Conclusion

3. Definition of innovation • Webster’s Collegiate Dictionary: to introduce as or as if new • Most innovations are about improving existing products and process

4. Definition of innovation • Miller (1992) argued that true innovations should have lasting impacts：futures contracts and cash settlement

5. Financial innovation originates from market imperfections • incomplete markets • tax • regulatory constraints • information asymmetry induces agency problem

6. Financial innovation originates from market imperfections • transaction cost • moral hazard • globalization • risk • NO ONE explanation works

7. Ironically, sometimes financial innovation would aggravate the very causes for innovation • Financial innovations related to the subprime problem • Financial institutions wanted to reduce risk • SIV and securitization • Financial institutions wanted to make money • The subprime crisis spread at a global scale • The subprime products were much riskier than people had expected • The subprime crisis resulted from moral hazard • Financial institutions bought products based on credit ratings and did not bother to worry about liquidity risk and valuation

8. Ironically, sometimes financial innovation would aggravate the very causes for innovation • Structured products sold to retail clients • Clients (probably financial advisors too) do not understand the complicated structure of the products • Financial institutions wanted to make money • The structured products were much riskier than people had expected • The dispute between sellers and clients resulted from agency problem

9. The future trend of financial innovation • Transparency will be crucial • More likely products will be designed based on liquid underlying assets • US and European financial institutions will be scrutinized more for their financial products—Regulators will focus on • Transparency • Liquidity • Valuation • Governance of Institutions designing products will be stressed • Product designer will be look to behavioral finance more and more • Financial e-commerce

10. A local Taiwanese financial innovation—Internet Huei • Shacom.com created the Internet Huei • It is a kind of traditional Huei without Huei Shou • There is bidding on the first allocation date • Participants are guaranteed by the bank • The Bank is responsible for clearing and settlement • Borrowers and Lenders determine their own interest rate • Participants who bid early are likely borrowers • Participants who bid later are likely lenders • Borrowers and lenders share the traditional loan-deposit interest spread

11. A local Taiwanese financial innovation—Internet Huei • The Internet Huei is a type of e-commerce • The innovation is protected by many patents • The innovation is in “the process of bidding to determine interest rate” and the clearing and settlement mechanism • The innovation overcomes the shortcomings of traditional Huei • Default risk • Liquidity • interest rate references • Huei Shou advantage

12. Conclusion • Thank you for your attention