Financial innovations in the capital market Introduction Financial innovation has been a continuous and integral part of growth

of the capital markets. Greater freedom and flexibility have enabled companies to reinvent and innovate financial instruments. Many factors such as increased interest rate, volatility, frequency of tax and regulatory changes etc. have stimulated the process of financial innovation. The deregulation of financial service industry and increased competition within investment banking also led to increased activities to design new products, develop better processes, and implement more effective solution for increasingly complex financial problems.

Types of financial innovations in the capital market There exists three types of financial innovations. First, there are institutional innovations. Such innovations can affect the financial sector as a whole, to the establishment of new types of financial intermediaries, or to changes in the legal and supervisory framework. Important examples include, formalizing informal finance systems, reducing barriers for rural people accessing finance, or setting up a completely new service structure. Secondly, there are process innovations. Such innovations cover the introduction of new business processes leading to increased efficiency, market expansion, etc. Examples include office automation and use of computers. Thirdly, there are product innovations. Such innovations include the introduction of new credit, deposit, insurance, leasing, hire purchase, and other financial products. Product innovations are introduced to respond better to changes in market demand. Financial innovation is viewed as the engine driving the financial system towards its goal of improving the economy. Merton (1986) cites the U.S national mortgage market, the development of international markets for financial derivatives and the growth of the mutual funds and investment industries as examples where financial innovation has produced enormous social welfare gains. The aim of financial innovation is to make different services (loans, deposits, investment fund units, debt instruments, shares, derivatives for risk management, currency exchange, payments and etc.) offered by financial system cheaper and more available for clients and to increase their quality, which is an assumption for a long run sustainable growth of economy (Campbell, 1988; Tufano, 2003). As a result of financial innovation the financial systems ability to fulfill following functions will improve: to determine the market price of financial instruments, to guarantee liquidity for instruments (financial markets), to be a source of companies capital (loans, new stock and debt issues), to encourage savings and investments (risk-taking) through risk sharing and diversification (investment funds, pension funds); to offer risk management products (derivatives and insurance).

Financial intermediaries funds Financial instruments Financial markets Financial services Financial techniques

Collateralized debt obligations (CDOs) are a type of structured asset-backed security (ABS) with multiple "tranches" that are issued by special purpose entities and collateralized by debt obligations including bonds and loans. Each tranche offers a varying degree of risk and return so as to meet investor demand. CDOs' value and payments are derived from a portfolio of fixedincome underlying assets. A type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds' prospectus. New financial markets like that of commodity derivatives, real option markets and insurance derivatives are examples of financial innovation in the capital market. Such financial instruments provide a flat form upon which investors both local and international can do business. In the Kenyan capital market these forms of financial innovation have not been introduced however they may be introduced in the near future as the market evolves. New financial services such as internet trading or internet banking Emergence of e-trading or e-banking in the capital market is also a form of financial innovation, these forms of financial innovation enhances efficiency in security trading. E-trading makes it possible for investors to transact without them going physically in the trading floor. E-trading enables investors to monitor their securities wherever they are and do business round the clock. Through e-trading the volume of trade in increased while cases of fraud are also minimized. For instance the capital markets authority in Kenya has automated the Nairobi Securities Exchange thus forming a flat form for financial innovation. New financial techniques such as Value at Risk Value at Risk is a widely used risk measure of the risk of loss on a specific portfolio of financial assets. For a given portfolio, probability and time horizon, Value at Risk is defined as a threshold value such that the probability that the mark-to-market loss on the portfolio over the given time horizon exceeds this value (assuming normal markets and no trading in the portfolio) is the given probability level. SMEs section Financial innovation in the capital market may also involve development of an SME segment to cater for small and medium sized companies. The NSE recently formed this segment to enable small and medium sized companies to raise capital for growth. This form of financial innovation helps small firms to raise funds from the public to enable them grows their business.

Asset Securitization as a Financial Innovation Asset securitization means that more than one institution may be involved in lending capital. Consider loans for the purchase of automobiles. A lending scenario can look like this: A commercial bank originates automobile loans

The commercial bank issues securities backed by these loans.

The commercial bank obtains credit risk insurance for the pool of loans from a private insurance company

The commercial bank sells the right to service the loans to another company that specializes in the servicing of loans

The commercial bank uses the services of securities firm to distribute the securities to individuals and institutional investors.

All in all, financial innovation can help to increase the efficiency of the financial system, which facilitates the operation of monetary policy, but at the same time complicates the environment in which monetary policy operates. To deal with this complexity, central banks need to respond by monitoring the financial landscape, by following developments closely and by trying to predict the consequences of innovations that, at first, may appear very marginal. The ECB's monetary policy strategy is well designed to deal with these challenges. Although it gives a prominent role to money, it also takes into account possible influences of financial innovation on monetary aggregates. Furthermore, through its examination of non-monetary indicators, including both real and financial variables, the information from monetary aggregates can be cross-checked, which makes monetary policy more robust and less dependent on single indicators that may become distorted by financial innovation. Financial innovation increased dramatically since the 1960s, particularly in the late1970s.Although financial innovation can be result of arbitrary regulations and tax rules, innovations that persist after changes in regulations or tax rules, designed to prevent exploitation, are frequently those that offer a more efficient means for redistributing risk. The Kenyan security market in regard to spurring new financial innovations remains relatively poor despite being ranked the fourth best in Africa. The Kenyan capital market has few financial instruments and does not have the capacity to incorporate new financial instruments in the context of the current legal, regulatory and institutional framework.