Financial engineering has been disparaged as nothing more than paper shuffling. Critics argue that resources used for rearranging wealth (that is, bundling and unbundling financial assets) might be better spent on creating wealth (that is, creating real assets). Evaluate this criticism. Are any benefits realized by creating an array of derivative securities from various primary securities?
Over the course of time, a myriad of financial assets has evolved, For example, common stock, preferred stock, bonds and mortgages have a variety of manners of repayment, the frequency of payments, the risk associated with each investment vehicle and the return on each vehicle which is unique to each investment vehicle. For example, government bonds have semi-annual coupons so the bond holder incurs reinvestment risk if the coupon income is not spent. Mortgage loans have a prepayment option so the mortgage lender risks the return of the loan principal when rates decrease. Almost all debt contracts incur the risk that the borrower will not repay the loan (default or credit risk).
Over the last two decades, financial engineering has not only changed the way in which business is conducted in the finance world, but also the daily life of the average citizen in the leading economies. Structured products have been deemed weapons of mass destruction in some post-crisis comments, but it is fair to say that few people could understand the nature and risks of these instruments before the crisis financial engineering allows for a change in the risk and return patterns of traditional securities (Coskum, 2013).
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Financial engineering is a practice which can be used only when the related environment has been defined carefully (Neftci, 2008). Financial engineering facilitates the transformation and reshaping of risk. It thus supports the development of new products that decompose, transfer and pool risks to match the needs of users. Innovation thus delivers a broadening of financial choice that enables companies and households to improve their management of risk, with attendant gains in economic welfare (Bank of England, 2008). There are many factors influencing the increased activity of the financial institutions in creating and implementing financial innovations, the most important being: globalization and disintermediation of the financial markets, increased volatility of market parameters, deregulation and liberalisation of capital flows and the dynamic development of communication technologies (Coskum, 2013).
Financial engineering is clearly something more than paper shuffling, it is in sync somewhat with the morphing of capitalism. As the financial instruments become riskier or ever-changing, then the financial market creates additional financial instruments that allows families to reevaluate their portfolios and their willingness to assume risk. It creates different options for the investors. These financially engineered products, which are claims on a large pool of underlying assets, may be worth more than the value of the underlying assets due to the redistribution of the risks.
Financial engineering allows a restructuring of sorts and a perhaps large and certainly different selection of investment vehicles made derived from real assets. So the risk is in most cases lessened and the return will change as well depending on the risk. Merely relying on real assets alone is creating more perceived or real risk from the investors.
Securitization requires access to a large number of potential investors. Securitization is pooling loans for a variety of purposes into standardized securities backed by those loans, which can then be traded like any other security (Bodie, 2014).
Globalization which is a more macro concept than securitization describes the process by which national economies have become increasingly interdependent. Economic, political, and technological changes are influential drivers of the process. Financialization may be defined as the expansion of financial trading and abundance of new financial instruments. Globalization and financialization is not the same thing. Financialization needs globalization and, in turn, globalization takes place through financialization (Aalbers, 2009). Financialization impacts other societal institutions (including the government) as financial markets and instruments become more influential. It also includes an increased reliance on short-term and liquid assets (Buchanan, 2015).
Securitization falls under the auspices of globalization and financialization. The investment world is a global operation. The financialization is the trading of financial instruments and also the creation of new instruments. Securitization is literally the creation of financial instruments that are safe and marketable and insured and secure for the potential investors (Aalbers, 2015).
Securitization is a global multi-trillion dollar market that embodies financialization. As an example of securitization “run off the rails” the recent financial crisis, securitization fueled an unsustainable increase in mortgage credit. As the recent financial crisis reveals, securitization increased credit market volatility and was heightened by a reliance on debt and incentive schemes that focused on short-term profits. As extensive global reform of the securitization market takes place, there are serious reservations about the sustainability of securitization. The story of securitization comes down to the globalization of finance and the declining importance of banks (Buchanan, 2015).
As a final note of the securitization, eventually financial asset investment crowds out real asset investment, an activity described as “distributive” rather than “creative” (Orhangazi, 2008). Due to the transference of income from the real sector to the financial sector, financialization is also credited with contributing to increased income inequality, wage stagnation and destabilizing economies due to an increasingly complex and opaque financial system (Giron, 2013).
The main role of the financial markets and institutions in all economies is to improve the efficiency of capital allocation and encourage savings, hence boosting growth, leading to further capital formation, the mobilization of savings, the management of risks, and the facilitation of transactions. The financial system may achieve this through either credit or equity markets, or both. There is considerable country-specific variation in the elements of the financial sector that are able to channel resources from savers to investment opportunities.
Although a vast theoretical and empirical literature on the relationship between financial sector development and economic growth suggests that financial systems may promote long run economic growth, there is no general consensus about the impact of either stock markets or banks on economic growth. Theory provides conflicting predictions about the relationship between stock markets, banks, and economic growth. Many researchers are becoming increasingly convinced that well-functioning financial systems can boost economic growth by ameliorating information and transaction costs (Levine, 2005).
However, some models show that higher returns from enhancing resource allocation may lower saving rates. If sufficiently large externalities are associated with saving and investment, financial development slows the long-run growth rate (Ghazouani, 2007). Although the existing literature provides substantial and wide-ranging evidence on the role of the financial system in shaping economic development, there are serious shortcomings concerning the functioning of the financial system (Cihák, 2012). First, researchers have no direct measures to determine the degree to which financial systems are successful in achieving their main role, mentioned above (Sevena, 2016).
Securitization eventually leads to disintermediation. In this age of financialization, in the financial systems of individual countries occurred many tendencies and phenomena influencing shape and functioning of financial intermediaries. The process may be interpreted and analyzed in many dimensions. Its defining and understanding is of crucial importance when one assesses its consequences for the financial stability and access to financial services. There is a diminishing trust in financial institutions (Marszalek, 2016).
In general, disintermediation means just removing the middleman or intermediary from any transaction. In the context of finance, the phenomenon may be investigated in two meanings. First, it can be understood as a decreasing importance of banks (mainly “traditional” ones, focused on deposits loans operations) among financial intermediaries (Marszalek, 2016). Accepting this approach, as the most basic measure of disintermediation scale and dynamics may be treated (decreasing) share of banking assets in the assets of the financial sector in general (Marszalek, 2016).
Second, disintermediation may be perceived as withdrawal of funds from intermediary financial institutions, such as banks and savings and loan associations, in order to invest them directly. Thus, in such approach, the process is considered as broader, as it implies a diminishing role of the financial intermediaries at all. Participants of the market processes give up help and offer of financial entrepreneurs and make attempts to invest or raise funds directly on the financial market. Among their incentives is the will to avoid excessive costs of financial intermediation, limited access to financial intermediaries offer or even practical reasons (Marszalek, 2016).
Disintermediation has significantly changed competitive position and role of the commercial banks within the financial systems. It concerned especially systems of the European type (bank-based), but the diminishing importance of “traditional” banks was visible also in countries with financial systems based on the market. It is worth noting that, among other factors, the important role in this decline of banking played the global financial crisis, contributing to growing distrust in financial institutions in general and in banks particularly. The customers, in part forced to this by credit crunch and tightening of banks’ policies and procedures, decided to limit their relations with banks.
Still, both the households and small entrepreneurs needed to fulfil their financial needs and a natural choice as to turn to other institutions. Thus, there emerged room for development of alternatives for commercial banking. Some of them were already well known institutions, like the cooperative banks or credit unions, while others – started to operate just in the last decade, like the social lending platforms. Their common future is more social character, as they function and operate closer to the clients, are more friendly for them and their offer is more convenient and transparent than the one in the large commercial banks (Marszalek, 2016).
References
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- Aalbers, M. (2015). Corporate financialization. The International Encyclopedia of Geography: People, the Earth, Environment and Technology. 39: 663-677.
- Bank of England, (2008). Financial innovation: what have we learned? Quarterly Bulletin. 48 (3), 330-338.
- Bodie, Z. & Kane, A. & Marcus, A. (2014). Investments (2nd ed). New York, USA: McGraw- Hill.
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- Coskum, Y. (2013). Financial engineering and engineering of financial regulation: guidance for compliance and risk management. Journal of Securities Operation and Custody. 6 (1), 81-94.
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