Working Paper Series: Special Edition of 2016 to 2018 Interns

1.0 Introduction Financial stability is one of the key objectives of central banks. A well-functioning financial system is important for economic growth, especially for the allocation of capital. The significance of finance in an economy and for economic growth naturally increases the importance of financial innovation (Levine, 1997). Since finance is an input for practically all production activities and a relatively large proportion of consumption activity, improvements in the financial sector are likely to have positive effects throughout the economy. Financial innovation plays an important role in making progress toward improved access to financial services and increased competition with the banking industry. According to Tufano (2003), “ Financial Innovation 10 is the act of creating and popularizing new financial instruments as well as new financial technologies, institutions and markets .” Others define it as the unanticipated improvement in the array of financial products and instruments as a response to continuous changes in the economic environment. Today, enterprise, intellectual assets and innovation are the driving force for economic growth and improvement in standard of living (Mwinzi 2014). The improvements in the financial sector have led to an increase in the number of financial institutions as well as the level of sophistication, with new payment systems and a variety of products and services offered. This is as a result of technological advancement and increase in competition due to an increase in the number of institutions. The theory of financial innovation is centered on the provision of opportunities for risk sharing. For economists, it is natural not only to ask how innovation comes about, but also whether the market is doing a good job at providing the institutions and instruments needed. The purpose of the introduction of a financial innovation to market participants is to minimize costs and reduce the risk of exposure through the moving of funds across time and space (e.g., savings accounts), the pooling of funds (e.g., mutual funds), managing risk (e.g., insurance and many derivatives products) and facilitating the sale or purchase of goods and services through a payment system (e.g., cash, debit cards, credit cards) (Merton, 1992), among others.

10 According to Laeven et al (2012) financial innovation is not limited to the invention of new financial instruments nor is it limited to financial institutions; it consists of more mundane financial improvements such as improvement in data processing and credit scoring, new financial reporting procedures and so on.

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