【MN3005】Financial Services
Financial Integration and Financial Innovation-FinTech
- The literature on financial integration uses different price-based measures. Discuss two price-based measures
Answer guidelines:
- Measure based on difference between local yields and some benchmark, which is often the German yield; time variation in spread is an indicator of integration (but: problematic under stress market conditions)
- Dispersion of prices: standard deviation of yields across countries. Financial integration increases when the cross-sectional standard deviation has a downward trend (moves towards zero)
Degree of financial integration increases when cross-sectional standard deviation sd(i) moves downward (towards zero):
- Explain why interest rates on bonds issued by different countries in the euro area can have different yields even if they have the same remaining maturity. And explain how this could be problematic as to measure the financial integration.
Answer guidelines:
Interest rates reflect also credit risk and liquidity of the bond. Credit risk of national governments in the euro area differs.
Price-based measure such as calculating the difference between local yields and benchmark yield can be problematic, as they may not adequately control for underlying risk characteristics such as credit risk.
- Explain why financial market integration can help insuring against idiosyncratic risk.
Answer guidelines:
When a region is hit a by a negative shock that is specific for that region only (i.e. idiosyncratic), consumers in that region may maintain their consumption by borrowing from other regions in the area. Consequently, consumption of agents in one region co-moves with that of agents located in other regions of that area, while consumption does not co-move with region-specific shocks.
- Explain the underlying assumptions of quantity-based approach for measuring the financial integration.
Answer guidelines:
One way to assess the progress made towards financial integration is to consider whether the barriers to entry for foreign economic agents willing to invest in a specific region have been reduced over time. If so, cross-border ownership of securities should increase over times. On the other hand, if market is more integrated, it should have less home bias (activities concentrated in the domestic market). i.e. the degree to which agents invest in domestic asses even though risk is shared more effectively if foreign assets are held, as a sign that financial integration is not complete.
- Critically examine the consequences of financial integration
Answer guidelines:
use literature (theretical and empirical) to support the discussion.
- More opportunities for risk sharing and diversification
Obstfeld (1994) and Acemoglu and Zilibotti(1997) overall improve efficiency of investment).
Fratzscher, M. (2002) found evidence in the Euro zone that highly integrated financial market offers few opportunities to diversify portfolios within the Euro zone
- Better allocation of capital
Gourinchas, P. O., & Jeanne, O. (2006): developed (capital-abundant) to less developed (capital-scarce) countries on economic growth and convergence.
However, Boyd and Smith (1992) demonstrated that weak financial and legal systems are likely to induce a capital outflow from capital-scarce countries to capital-abundant countries with better institutions.
- Potential for higher growth and more functioning domestic financial system
Klein and Olivei, 2000; Levine, 2001: intensification of competition and the importation of financial services, with positive growth effects
On the other hand, Mendoza, Quadrini and Rios-Rull (2009) suggested that international financial integration may cause large, persistent global imbalances and their portfolio composition among countries with heterogeneous domestic financial markets.”
- Impact on financial stability and structure of financial system
Haan, Oosterloo, and Schoenmaker (2015): Highly integrated financial market means more risk sharing and leads to greater interdependence and subject to systemic risk of the crisis.
- Explain two technologies underpinning the FinTech
Answer guidelines:
Provide two: for example
- Blockchain. A system in which a record of transactions made in bitcoin or another cryptocurrency is maintained across several computers that are linked in a peer-to-peer network
- Cryptocurrency. A digital currency in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, independently from a central bank.
- Provide one example of FinTech that is disruptive and complementary to the traditional financial services respectively.
Answer guidelines:
Examples:
- Disruptive: blockchain based Fintech such as initial coin offering can by pass the financial intermediaries and also the financial markets to provide capital to fin-tech start-ups.
- Complementary: robo-advisory service that can be used to enhance the traditional financial services model.
- Critically examine whether FinTech improve the efficiency of resource allocation in the financial system.
Answer guidelines:
According to Philippon (2016) analysis despite the ongoing development of financial innovation, the scope for efficiency improvements in the financial sector was fairly stable about 2%. However, he also argued that financial innovation led to less improvement in the social welfare possibly due to the impediments to entry. Along with policy induced distortion such as “too-big-to-fail”, this has caused concentration, market power, and lack of competition. As a result, this created a barrier to entry. Established financial intermediaries with large balance sheets, still are the major player in the financial services fields. FinTech companies filled gap (disruptive) where large debt-funded balance sheets are not needed.
In the end, the extent of which FinTech innovations benefits ender users depends on the social costs of innovations, risks and regulatory responses.
- Discuss how well the cryptocurrencies have functioned as money
Answer guidelines:
- Functions of money:
- Store of value
- Medium of exchange
- Unit of account
Using this definition, many scholars (e.g. Ali et.al 2018) concludes that cryptocurrencies do not function very well as money.