(MENAFN- Arab Times) Central Bank of Kuwait (CBK) Governor Mohammad Al-Hashel said here Tuesday innovation in finance has become a major driver for growth and welfare in different world countries.

"It goes without saying that innovation has been one of the key drivers of growth, productivity and prosperity across countries and over time," Al-Hashel addressed the 7th Euromoney Conference held here today.

In the field of finance, the role of innovation can be discussed from a variety of angles; after all, our modern world of finance is an innovation in itself, under a constant evolutionary cycle spanning over decades.

On examples of innovative developments, he said: "Let me start with central banks. One relevant example of central banks' innovative approach towards policymaking has been the use of unconventional monetary policies (UMPs) in recent years." "You will recall that in the wake of global financial crisis, the central banks of major advanced economies provided substantial emergency liquidity support to their battered financial systems. Moreover, policy rates were swiftly slashed in successive intervals - for instance, the Federal Reserve cut interest rate from 5.25% in July 2007 to between 0.00% - 0.25% by January 2009. Likewise, the Bank of England lowered its policy rate from 5.75% in July 2007 to 0.5% by March 2009.

However, even as the policy rates hit the zero-lower bound through successive cuts, financial markets remained in turmoil, real output kept declining and threats of below-target inflation loomed large. As economic theory would tell us, central banks were confronted with a liquidity trap at the zero-lower bound, he said.

No longer being able to cut nominal rates any further, central banks in major advanced economies were compelled to adopt an innovative policy stance. So the central banks pursued UMP, and rounds of quantitative and credit easing were introduced, he added.

It is true that the use of quantitative easing (QE) was not entirely a novel concept as the Bank of Japan had pursued the same since back in 2001. However, the scale, the length and the impact of QE and other innovative measures introduced since 2008 have been unprecedented. The Federal Reserve alone conducted three different rounds of QE programs, purchasing financial assets worth more than $3.5 trillion € an amount roughly equal to the size of Germany's economy.

On the positive side, these innovative policies have definitely helped in improving credit conditions, providing liquidity, bringing yields to historically low levels and lifting growth. Though recovery is still somewhat fragile and uneven across the major advanced economies, the economic outlook has turned clearly positive in both the US and the UK.

Yet, the pursuit of UMPs has also spawned debate about their unintended consequences, their diminishing efficacy and their serious implications for global financial stability, Al-Hashel noted.

Highlighting a few concerns in this regard, he said: First, the UMPs have helped pushed interest rates in many advanced countries to record low levels. In fact, rates in the Eurozone have turned negative - which effectively means depositors are being charged to make deposits.

Returns on risky and non-risky assets have sharply converged, evident from the extreme compression in sovereign credit spreads in the Eurozone. This has increased the danger of mispriced sovereign risks. Moreover, with short-term rates at zero lower bound, investors are investing in long-dated securities at very low yields, pushing even term premium into negative territory. These investors are likely to suffer significant losses when long-term yields ultimately normalize.

Second, with ultra-loose monetary policies, prices of financial assets have seen a rapid climb. This has increased the risk of a hard landing in the future particularly when the current level of liquidity is ultimately withdrawn.

Impact

Third, despite historically low interest rates, the impact on real economic activity has remained limited amid weak investments. As the International Monetary Fund (IMF) once put it, 'there has been a lot of financial risk taking but little economic risk taking'.

Fourth, UMPs have also caused significant portfolio rebalancing amid shifting capital flows. Between 2009 and 2012, emerging markets received about $4.5 trillion of gross capital flows, as investors rebalanced their portfolios away from US Treasuries in search of higher yields.

Fifth, despite enhanced communication of policy paths, the timing and pace of reversals in UMPs can rattle markets. In any case, orchestrating an orderly exit would not be easy.

A related complication is the divergence in monetary policies across advanced countries; while the US and UK are preparing for their first lift-off in over eight years, the ECB and BOJ are continuing with their ultra-loose policies.

So even if entry into this innovative and unconventional territory of monetary policy has been well coordinated, divergence in policy paths would make an orderly exit more challenging, not only for the countries concerned but for the global economy as well, he believed.

Regulators are supplementing their existing microprudential toolkits with macroprudential measures - aimed at addressing systemic vulnerabilities across institutions and over time, Al-Hashel noted.

Though the concept is not entirely new, macroprudential policy is increasingly being recognized as a valuable tool to address specific financial stability issues where the use of monetary policy on its own appears to blunt a tool to be entirely effective, he added.

However, challenges have also emerged about the appropriate calibration of macroprudential tools, effective coordination among various regulators and even the potential implications for central banks' independence, the CBK governor elaborated.

The pace of innovation in financial products and instruments has been particularly staggering in the run up to the global financial crisis. For instance, within 10 years leading up to 2007, the total outstanding value of interest rate swaps and other derivatives surged from $75 trillion to $600 trillion, almost eleven times the value of global GDP. During 2007 alone, the global derivatives market grew by almost 50 percent. On the positive side, the development of innovative financial instruments has empowered institutions to accomplish their financial requirements and effectively hedge their risks. Individuals are also better able to smooth out their consumption over time, he said. Likewise, the availability of catastrophe bonds and weather derivatives have helped countries insure against risks from natural disasters and adverse weather events. But the growing complexity of financial instruments (e.g: CDO-squared) has also generated debate whether financial innovations have gone too far.

In general, the pooling and dicing of risks has enabled investors to take risks that specifically suit their risk appetites. It has also resulted in cleaner pricing of various dimensions of risk.

He recalled that on July 8th this year, computer systems at the NYSE went down for nearly four hours in the middle of the day, bringing to a halt the epicenter of America's financial markets. Moreover, with the growing footprint of modern technologies, the nature of risks has also evolved significantly. As various hacking episodes illustrate, now fraud can be perpetrated swiftly, remotely and on a massive scale, he said. While the chances of frauds like tampering with cheques, as shown in Spielberg's 'Catch Me If You Can' are getting remote, the risk of cyber-attacks is on rise. In 2013, hackers stole the personal financial data of 70 million customers at 'Target', a major discount retailer in the US. The breach cost Target more than $150 million and the CEO his job, Al-Hashel pointed out.

To conclude, every innovative policy, product or a system brings its own unique costs and benefits. It needs to be ensured that benefits of any such innovation must outweigh its costs, at least in the long run, if not immediately, he pointed out. Admittedly, it is difficult to reliably predict the negative outcomes of an innovation.

A key challenge is that our earlier experiences are a poor guide when it comes to determining the outcome or impact of innovations. Innovations are by their very nature a departure from the past. And ironically, the more radical that innovations are, the less useful our past experiences become.

Still, societies need to encourage innovation as maintaining the status quo is not a solution. After all, standing still would mean falling behind, particularly in a world that is pacing forward, he concluded.