Finance Financing Finance: Does Financial Innovation Crowd out Credit Creation by Diverting Consumers and Business Loans Back to the Financial Sector, and How This Affects the Banks’ Performance through Investment, and Lending?

Abstract

The traditional innovation-growth view posits that financial innovations help facilitate risk sharing, complete the market, and ultimately improve allocative efficiency. However, financial innovations are often attributed as the root cause of the Global Financial Crisis, by engineering securities perceived to be safe but exposed to neglected risks. Financial engineering often is done by banks and investment houses led to the creation of structured products that often compete with conventional lending in the placement of the depositors’ money. Moreover, as there seems to have a lower risk (on paper) due to the use of innovative derivatives, they are often preferred over risky consumer and corporate financing. In this study, we tend to test this hypothesis and explore whether financial innovation crowd out consumer and corporate credit creation and would this affect the long-term returns and growth of banks in Pakistan. For this, we presented a model showing financial innovation (measured by off-balance sheet items as a percentage of total assets), affect bank growth (increase in deposits & net income) as well as profitability (ROE & ROA) indirectly through the mediation of investment, lending, and advance ratio to deposit (ADR). For this purpose, data of 25 banks operating in Pakistan were taken from the year 2010 to 2019, collected from annual reports. Data were analyzed using Structured Equation modeling. The results showed that financial innovation seems to have a negative and significant impact on ADR, however a positive impact on lending. This suggested that consumer and corporate finances might increase with financial innovations but compared to deposits, they are decreasing. This clearly showed that financial innovation crowds out credit creation. At the same time, its effect on investment seems to be significant. Moreover, among the three mediators, the only investment seems to have a positive effect on profitability but a negative effect on growth. The effect of credit creation on growth does not seem to be substantiated. The study showed that financial innovation does not seem to affect either profitability or growth in the above-mentioned mediation framework. Hence, the findings suggested that there are some downsides of financial innovation as it crowds out the credit creation process that could be a crucial engine of economic growth.