Financial Innovation: An Analysis Of Its Impact On The Economic Crisis

The bankruptcy of New Century Financial Corp, which is the second biggest subprime institution, is the beginning of the subprime crisis. This crisis soon spread to the whole world, resulting in an economic recession. No other crises in history are as strong as the subprime crisis, for it triggers such a bad effect on the global economy. Specifically, China is one country which suffered a huge loss. America is one of the most important countries for Chinese exports. The subprime crisis decreases the total amount of American consumption, which consequently decreases the volume of Chinese exports. Thousands of exporting firms die, which brings a high unemployment rate. Additionally, assets of the banks which buy the bonds depreciate. Governments of the leading countries hold summits to discuss the way out. At the same time, I think it's also necessary to consider the root of the problem and learn a lesson from it. This article will attempt to reach an understanding of the positive and negative effects of financial innovation by analyzing the subprime crisis and discuss how to maximize the positive functions of economic development through an effective supervising system.The thesis can be divided into four parts:Part 1, preface, states the background, significance, method, and innovation of this research. The outbreak of this disaster causes people to fear innovation, and some scholars question the rationality of the act. Because of the significant role this innovation plays in the process of economic development, this economic research should not be stopped due to mistakes made. In fact, a more sensible approach is to set up an institution to mitigate risk in order to avoid the future existence of a similar crisis.Part 2, theories, first defines financial innovation, and then it includes a brief description of its cause, history and functions. Financial innovation is the evolution of the economic instruments, securitization, off-sheet business, and globalization of markets. It starts with a deviation from financial supervision, and becomes popular with the pursuit of profit. Not only does financial innovation broaden the source of capital for banks, but it also provides methods of investing and avoiding risk. Meanwhile, it also aggravates the instability of the market, making macro-control more difficult. Furthermore, the relation between financial crisis and financial innovation is important. A financial crisis is when"all or most of the financial indexes, short-term interest rates, and asset prices suffer from a sharp, short periods of deterioration and commercial bankruptcy."Economic development is a history of the continuous cycle of how a financial crisis is begot from financial innovation which will in turn repair the crisis. In the end, this section lists the various theories of supervising, such as public benefit theory, creditor's rights, protection theory, financial risk control theory, and financial supervising theory.Part 3 refers to the cause, process, and effect of the subprime crisis, and then this section provides an introduction of the derivative instruments that exist during the crisis. These instruments include residential mortgage-backed securities (RMBS), collateralized debt obligations (CDO), and credit default swaps (CDS). Not only does excessive innovation increase the severity of the crisis, but it also plays a significant role in the recovery of American economy since the 2001 recession. Because of this, financial innovation should not be recognized as the root of the crisis. The real source is excessive innovation with a lag in establishing the new supervising system.Part 4 will focus back on China's financial market. Mixed management is the system in which a commercial bank (e.g. Morgan Stanley) can not only run the business of banks, such as deposit and loan, but they are also allowed to run the business belonging to investment banks (e.g. JPMorgan Chase & Co.), such as initial public offering. Utilizing this system of management is becoming the trend, and the supervision required for mixed management cannot accommodate to the rapidly changing situation. This section explains the problems of present system. China's financial innovation is insufficient compared to that of developed countries. Also, because mixed management is so critical in the development of an economy, it should be made more efficient through perfecting supervision. With the present situation of China in mind, some personally-developed suggestions and advice are as follows: keep running the system of separating supervision, set up a transparent information system, establish a well-rounded credit judgment system, and perfect the law of supervising.