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Financial Econometrics, Financial Innovation, and Financial Stability

Charles I. Plosser

Federal Reserve Bank of Philadelphia

abstract

Innovation in financial markets, spurred to a significant extent by develop- ments in finance theory and financial econometrics, has played a critical role in spurring economic growth. However, the current turmoil in financial mar- kets raises fundamental questions about the nature of financial innovation and the role of policymakers in maintaining financial stability. This paper ex- plores these questions, focusing on the complexities of modeling financial risk and the potential trade-off between policies aimed at combating short- run financial instability on the one hand and the potential financial market distortions and moral hazard that can result from such policies on the other. ( JEL E32, E44, E50, G18)

keywords: credit risk modeling, financial innovation, financial stability, monetary policy