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.