Financial Innovation in Financial Markets - A Reassessment

In last decades financial innovation and the rise of new classes of financial institutions, combined with a change in the trading behavior of traditional institutional investors, have been contributed largely to increased market liquidity. Financial innovation has been considered to lower cost of capital, reduce financial risks, improve financial intermediation, and hence, welfare enhancing. However, financial innovation is not risk-free; it can create or exacerbate risk. The current financial turmoil is there to remind us that financial innovation is not a smooth process. This paper, therefore, studies the fundamental concepts and factors that drive financial innovation, and focuses on the inherent benefits and shortcomings as learnt from the recent financial crisis. The paper also attempts to focus on the Reserve Bank’s policies implemented so far to arrest the global contagion that originated due to flawed innovation process.