Something clearly has to give here – investors know – and must remember – that there is no such thing as a free lunch, and that additional return involves additional risk. The  BIS central bankers’ speeches  9  macro-prudential concern is that the reach for yield encourages financial innovation and growth in some parts of the financial system where the risks are not well understood,10 especially if it leads to greater interconnectedness within the banking system. This is one area which is likely to warrant further attention and analysis by the FPC in due course. Financial innovation and the emergence/growth of new products The financial industry is characterised by its tendency to innovate, continuously designing and offering new financial products to its customers. In my view, financial innovation should be seen as a “good thing” in normal circumstances. It can lead to a more efficient allocation of capital and a reduction in the costs of financial intermediation, both of which should help sustain real economic growth. For example, the rapid growth of electronic trade execution in the foreign exchange market has increased the speed and ease with which trades can be conducted. That should ultimately make international trade cheaper, bringing with it the associated benefits. Improvements in technology can, by facilitating wider market access, also lead to improved price discovery and market liquidity. Moreover, innovation can help issuers align the risk characteristics of new products more closely to those that investors demand.
Chart 2  Chart 3  Advanced economy corporate bond spreads(a)  Implied volatilities in selected markets(a)(b)  Basis Points 1000 Non-investment grade 900 corporates (RHS) 800 Investment grade 700 corporates (LHS) 600  Basis Points 2500  2000  1500  500 400  1000  300 200  500  100 0 2005 2006 2007 2008 2009 2010 2011  0  Sources: Bank of America/Merrill Lynch. (a) Option-adjusted spreads over government bond yields. Sources: Bloomberg, British Bankers’ Association, Chicago Mercantile Exchange, Euronext.liffe, JPMorgan Chase & Co. and Bank calculations. (a) Three-month option-implied volatilities. (b) Data to close of business on 14 June 2011. (c) WTI crude oil. (d) Average of FTSE 100, S&P 500 and Euro Stoxx 50. (e) Average of five-year on-the-run iTraxx Europe main and CDX North America investment-grade. (f) Average USD/GBP. of  USD/EUR,  EUR/GBP  and  (g) Average of three-month short sterling, eurodollar and Euribor. BIS central bankers’ speeches  3  Chart 4  Chart 5  Bid-ask spreads on selected assets(a)(b)(c)  International equity prices(a)  Corporate bonds  Indices: 2 January 2007 = 100 120  Indices: January 2005 = 100 1400  Government bonds Equities (d)  110  1200  100  1000  90  Commodities Currencies Interest rate swaps  80  800  70  600  Euro Stoxx 60  FTSE All-share  400  S&P 500  0 2005 2006 2007 2008 2009 2010 2011  Sources: Bloomberg, calculations.