Financial Innovation

Financial Innovation, Technology, Regulation and Public Policy

As the recent financial crisis begins to fade from memory we are starting to see behaviors in the world of financial innovation reverting to old methods and practices. Is it a good thing? Perhaps…

However, misunderstood financial innovations such as securitization, which led to the financial crisis through the sub-prime debacle in the United States, pose an ever present danger to the financial industry. Regulators and supervisors everywhere, as guardians of the various components of the world’s financial system, do still not clearly understand the implications of financial innovation. Often too this is clouded by public policies which as the basis for such oversight are suspect as to which “public” they are intended to benefit. This is especially the case in the uses of technology in the provision of financial services.

The word “innovate” means to bring in novelties or to make changes. Financial innovation extends this simple definition to the financial world. However, here the simplicity ends with a plethora of products, processes and methods that have been applied to the spectrum of the financial world – some good and some bad.

What drives financial innovation? Simply put – self interest, which finds expression through Adam Smith’s “invisible hand”. Financial institutions seek out, through the innovative process, the most efficient cost effective way to maximise their profits either on existing products or potential new ones.

There are two basic drivers of financial innovation which result from the barriers that a bank faces in reaching its financial goals – competition and regulation. To beat these barriers banks engage in completion of two sorts – competitive or circumventive. The first is pretty obvious as all banks seek to maximise their profits and they do this by competing with other players in the market.

The second, circumventive, is a little bit more obscure. In all jurisdictions financial firms are faced by a plethora of rules and regulations, imposed by the banking and regulatory authorities on how they conduct their business. These are the regulatory barriers that a bank faces. These barriers may often be overcome by innovation – hence the term “circumventive innovation”.

The classic illustration of this is the development of the humble Automated Telling Machine (ATM) which was introduced first in the United States as a circumventive innovation, to get past retractions on branch banking. The idea was quickly picked up, first in Europe, and then globally as a competitive innovation. European banks had no restrictions on the number of branches they could have but labour policies created limitations on for example working hours among many other issues. In the ATM the European banks found a new “staff member” who (1) was cheaper than a human teller, (2) could work all day and night, (3) was accurate, (4) did not need a physical branch to support it. There were many other plusses a well, not to mention the ability to widely expand the range of products and services that could be offered.

In essence, one type of innovation (circumventive) morphed into another (competitive). This interaction goes on constantly and is a key feature of the dynamics of a constantly evolving financial system. And technology has been a leading driver of this process. We see this in action all the time in many different ways.

Recently I came across a news item that indicated that Citibank had embarked on a project to make deep inroads to consumer banking in India – a vast market. Notwithstanding the size of the market in India, which is on a par with that of China, anyone trying to establish or expand their business in the worlds largest democracy has a massive hurdle to overcome. For a bank one of these hurdles is very tight regulation and the restrictions placed on banks in growing their branch networks.

The Reserve Bank of India, which is the country’s central bank, tightly controls the number of new branch licenses that are granted to foreign banks. This has a massive restrictive affect on the ability of such banks to grow their distribution networks.

To get past this limit on its physical presence Citibank has begun targeting India’s almost six hundred million mobile users. Now this is the “circumventive innovation” that I spoke of.

Citibank, who is one of the leading foreign banks in India with 42 branches and more than 450 ATMs – recently completed a six-month program in Bangalore to test the appetite of customers to make transactions through phones. The program was called the “Tap and Pay” pilot project.

During the project, the bank sold more than 3,000 phones especially enabled to make transactions over the mobile network. Customers made Rs26m (US$585,000) of purchases from 250 merchants. Citibank is now considering rolling out such services to its wider client base.

This case is a classic illustration of how financial innovations can be used an adapted to achieve other needs.

So, what is the message to bank regulators, supervisors and their policy makers? Well put simply “financial innovation or its implications are not always clearly understood”. These facts are critical to bank supervisors and regulators because innovative actions on behalf of the financial industry are not always benign or made for the general good. Equally so, public policy makers need to understand why some financial innovations take place and review their policies in the light of this. Very often restrictive practices are created for the wrong reasons – protection against genuine competition is often disguised as consumer protection.


Financial Innovation is a Fallacy

When the lending industry developed exotic loan products, they touted them as “innovation,” and they sold these toxins far and wide. Since these loans achieved the highest default rates ever recorded, it is apparent the “innovations” of the bubble rally were not entirely successful. The cutting edge is sharp. Innovators often pay a heavy price for attempts at advancement. Sometimes these advances lead to quantum leaps in human knowledge and understanding. Sometimes the time, effort, and money are merely thrown into the abyss. The financial innovations of the Great Housing Bubble are of the latter category.

It is amazing that a group of assumingly intelligent bankers came up with these exotic loan programs and expected a positive outcome. The “innovation” meme is nothing more than a public relations effort to convince brokers the products were safe to sell and borrowers the products were safe to use. It is hard to fathom the widespread acceptance of this nonsense, but that is the nature of the pathological beliefs of a financial mania.

Many in the lending industry think their work is like science that continually advances. It is not. It is far more akin to assembly line work where the same widgets are pumped out year after year. When lenders start to innovate, trouble is brewing.

The last significant advancement in lending was the widespread use of 30-year amortizing loans that came into favor after World War II. Prior to that time, home loans were interest-only, short-term loans with very high equity requirements (50% was most common). This proved problematic in the Great Depression as many out-of-work owners defaulted on their loans.

A mechanism had to be found to get new buyers into the markets and allow them to pay off the loan. The answer was the 30-year, fixed-rate amortizing loan. To say this was an innovation is a stretch as this loan has been around as long as banking has existed, but it did not become widely used until equity requirements were lowered. The lenders were willing to lower the equity requirements as long as the loan was amortizing because their risk would decline as time went by and the loan balance was paid off.

To be financially conservative is to accumulate wealth and to be risk adverse. It requires managing equity, paying down a mortgage loan, and allowing net worth to accumulate rather than depleting it via consumer spending through mortgage equity withdrawal.

Many people do not realize the risk they take on when they use some of the innovative loan programs developed during the bubble. Exotic financing terms are not exotic anymore. Interest-only, adjustable rates and negative amortization have become so ubiquitous that nobody seems to remember why 30-year fixed-rate mortgages are used. A home should be financed with a fixed-rate conventionally-amortized mortgage and a sizable downpayment. The reason for this is simple stress management: nobody wants to spend the next several years worried about a loan reset or the need for increasing house values or future salary increases.

People should not buy with the desire to make a fortune in real estate. Instead, they should purchase with the intent to have a stable housing payment, and a stress-free life.

Important Role of Financial System in the Economy

Important Role of Financial System in the Economy

The financial sector provides six major functions that are important both at the firm level and at the level of the economy as a whole.

1. Providing payment services. It is inconvenient, inefficient, and risky to carry around enough cash to pay for purchased goods and services. Financial institutions provide an efficient alternative. The most obvious examples are personal and commercial checking and check-clearing and credit and debit card services; each are growing in importance, in the modern sectors at least, of even low-income countries.

2. Matching savers and investors. Although many people save, such as for retirement, and many have investment projects, such as building a factory or expanding the inventory carried by a family micro enterprise, it would be only by the wildest of coincidences that each investor saved exactly as much as needed to finance a given project. Therefore, it is important that savers and investors somehow meet and agree on terms for loans or other forms of finance. This can occur without financial institutions; even in highly developed markets, many new entrepreneurs obtain a significant fraction of their initial funds from family and friends. However, the presence of banks, and later venture capitalists or stock markets, can greatly facilitate matching in an efficient manner. Small savers simply deposit their savings and let the bank decide where to invest them.

3. Generating and distributing information. One does not always think of it this way, but from a society wide viewpoint, one of the most important functions of the financial system is to generate and distribute information. Stock and bond prices in the daily newspapers of developing countries (and increasingly on the Internet as well) are a familiar example; these prices represent the average judgment of thousands, if not millions, of investors, based on the information they have available about these and all other investments. Banks also collect information about the firms that borrow from them; the resulting information is one of the most important components of the “capital” of a bank, although it is often unrecognized as such. In these regards, it has been said that financial markets represent the “brain” of the economic system.

4. Allocating credit efficiently. Channeling investment funds to uses yielding the highest rate of return allows increases in specialization and the division of labor, which have been recognized since the time of Adam Smith as a key to the wealth of nations.

5. Pricing, pooling, and trading risks. Insurance markets provide protection against risk, but so does the diversification possible in stock markets or in banks’ loan syndications.

6. Increasing asset liquidity. Some investments are very long-lived; in some cases – a hydroelectric plant, for example – such investments may last a century or more. Sooner or later, investors in such plants are likely to want to sell them. In some cases, it can be quite difficult to find a buyer at the time one wishes to sell – at retirement, for instance. Financial development increases liquidity by making it easier to sell, for example, on the stock market or to a syndicate of banks or insurance companies.

Both technological and financial innovations have driven modern economic growth. Both were necessary conditions for the Industrial Revolution as steam and water power required large investments facilitated by innovations in banking, finance, and insurance. Both are necessary for developing countries as they continue their struggle for economic development. But the effective functioning of the financial system requires, in turn, the precondition of macroeconomic stability.

How To Get Value From Your Financial Advisor

How To Get Value From Your Financial Advisor

There are two times in every business cycle where an Investment Advisor can add a great deal of value to their client.

We can add value at the top of the market where euphoria rules and at the bottom of the market when panic and a desire for capitulation dominate.

I think that euphoria is often mislabeled as greed. I think that it’s more than that. To me, it’s the complete loss of an adult sense of danger. In the euphoric state, investors unconsciously define risk as, ‘the danger that other people are making more money than I am’. When the euphoria hits you, you no longer fear or even accept the possibility of principal loss. Your only concern is that somebody somewhere owns stocks that are going up more than yours.

Panic invariably follows episodes of euphoria and is usually as deep as the euphoria was high. It’s axiomatic that the biggest bear markets are simply correcting the biggest bull markets. The market couldn’t have gone down 50% if it hadn’t just finished going up 12 times.

Hence there’s also a consistent relationship between the height of the mob’s euphoria at the top of a big bull market and the depth of their panic induced capitulation at the bottom of the bear.

It manifests itself as the unconscious belief that equity returns has been permanently broken, or at least that equities will not come back in the investor’s life time.

This time is never different. Neither the business cycle nor the market cycle has ever been, or ever will be, repealed.

It seems obvious because it’s obvious.

All market declines are temporary because the market propelled by the economy which it reflects is permanently rising.

All new eras end in ruin because all technological and financial innovation follows the same downwards arc from miracle to commodity.

So how does a trusted Investment Advisor add value at these times?

As an investment advisor, we often talk about ‘hand holding’ clients to get them through difficult markets

To me, it’s much more than that. Clients don’t get through times of crisis simply by having an empathetic and loving friend. Like Gordon Gecko said in the movie Wall Street. “If you want a friend, buy a dog.”

In my opinion, you manage panic by managing euphoria today.

Like any sport or business situation, success is achieved by planning and preparation.

The first step is to build and then constantly review your client’s their financial plan and the tradeoffs that the client decided to take. If their goals requires a 4% rate of return on their investments, their portfolio should look considerably different than if they need 8%.

The second step is to regularly rebalance their investment portfolios. Remember this is a risk reduction move and forces us to do what we should. Buy low and sell high!

My third point often gets overlooked. Don’t let investor’s in over their head. This is especially true for inexperienced investors. It’s been my experience that they are generally over confident, in determining how much risk that they can take. Theoretically losing 20% is considerably easier than actually losing 20% of your portfolio. What you don’t want is the ‘knee jerk’ reaction to bail out of a normal market downturn.

I think that the situation is very much like learning how to swim. Inexperienced investors should practice in the shallow of the pool end before they get dumped into the middle of a lake. After the new investor has practiced through a regular market cycle or two, you could increase their equity exposure to where they need to be in order to accomplish their investment goals.

Innovation Must Pay

Innovation Must Pay

When an innovation team is created by an organisation, everything is exciting and rosy at the start. Filled with hope for the future, sponsors attach themselves to their new silver bullet which will solve all their problems and wait for exciting results to arrive. In the first few months after they are created, the team can get away with practically anything.

Quite quickly, however, the innovation team will get called to account for their results or (more likely) the lack of them. All those excited stakeholders will begin to wonder if they might have gotten better returns on their money by investing in something different, such as, for example, a Lean initiative. Most of the time, this happens inside 18 months, and the team’s budget gets scrutinised very carefully.

While everyone will probably agree the team has done “valuable work”, the only justification they really care about is financial returns that the innovation team may have generated. Ultimately, if all the other available investment opportunities can justify themselves financially, and the innovators can’t, it is obvious where a rational business manager will direct future funding. This is especially true during a downturn, or any other time an organisation is under stress. So innovators need to pay their own way, if their programmes are to exist in the long term. Now, it is always the case that some innovations don’t actually have financial returns. For example, productivity improvements driven by information technology are often key candidates for an innovation team. These will often add significant new capabilities which make employees work better or more quickly, but may not result in a direct financial benefit.

Clearly, there’s value in doing such things, and a sophisticated innovation team will certainly pursue them, regardless of the chance they’ll pay. How then, does an innovation team reconcile non-financial projects with its (necessary) core drive to make real money? The answer is the team must adopt a portfolio approach to innovation. In doing so, they will start a range or projects, some of which pay well, and others which don’t. It is a natural consequence of this that the team will spend much more time on the former, and de-prioritise the latter, at least until they have met their financial objectives.