Welcome to the fifth session of chapter 5.
In our last session,
we tried to understand the government intervention
while looking into the financial system and
the banking industry within it.
In this session, we will focus on financial innovation.
Financial innovation can be defined as
the act of creating and
then popularising new financial instruments
as well as new financial technologies, institutions and markets.
It includes institutional, product and process innovation.
Institutional innovations relate to
the creation of new types of financial firms
such as specialist credit card firms,
discounting broking firms, internet banks and so on.
Product innovation relates to new products
such as derivatives, securitised assets,
foreign currency mortgages and so on.
Process innovations relate to
new ways of doing financial business
including online banking, phone banking and
new ways of implementing information technology and so on.
There are a wide range of
different types of financial innovations,
some of which are hedge funds, private equity,
Islamic bonds (Sukuk), shadow banking,
mortgage-backed securities and
collateralised debt obligations (CDOs).
Let’s have a look a bit more closely at
the idea of financial innovation.
What is financial innovation?
It’s a result of the change in the environment
that stimulates a search for new products and ideas
that will likely increase the bottom line.
It’s a search for profits
so there are generally 3 types of changes
that will drive the idea of financial innovation.
There’s a response to changes in demand or
a response to changes in supply or
a response to existing legislation.
So if you want to avoid new regulation of regulation
that is due to be introduced,
the easiest thing you can do is
change your location;
go to a location that is more friendly or
have less regulation;
that is the obvious response.
Let’s look at some of the response to changes
in demand or changes in supply.
An example would be bank credit cards and debit cards.
Many store cards existed before the Second World War
but after the technology was improved in the 1960’s,
this reduced the transaction costs of operating these products
and it also linked up the terminals or
POS (Point-of-sale) Terminals making it more accessible
and more uniform in it application and
making credit card programmes more profitable
and thus increase the usage of these types of products.
The success of credit cards
led to the development of the debit cards
which operate along the same idea or
concept-giving us direct access to our funds on deposit.
This is an example of financial innovation
as a result of changes in demand and technology.
From the financial innovation point of view,
many commentators would argue that
humble credit card is
one of the most important financial innovations
of the past 60 years.
The reason behind its yet-unrivalled success
has much to do with an economic theory
known as the two-sided market,
whereby a powerful network effect attracts both
buyers and sellers,
in this case cardholders and merchants,
onto a platform for the purposes of commerce.
Another example would be
in the area of electronic banking.
We have all used cash points also known as ATMs.
This was the first innovation
in terms of accessing funds from an ATM.
In addition,
you’ve got innovations in the Internet, Internet banking,
we’ve got telephone banking
which gives us a more comprehensive service.
We can have access to our balances;
we can actually transact over the phone and over the Web.
There are even virtual banks
where the only way to interact or
transact with the bank is online.
An example would be First Direct.
This is a very successful business model
because the operating costs are significantly
lower than the traditional bricks and mortar bank.
A more recent financial innovation
would be idea of securitisation.
Technical definition is the transfer of an illiquid asset
into a marketable capital instrument.
Basically what that means is selling on
an asset, re-packaging it and selling on.
So if a bank is holding a group of mortgages
it has lent to its customers,
rather than holding on to
all those mortgages until they all mature and
collecting payments for next 20 years
(however long the mortgages are owed for),
they can slice and dice those into different packages
that are more interesting for other investors.
So if I’m a pension fund manager and
I’m looking for low risk investments with stable, guaranteed income,
I might be interested in buying
some securitized mortgage products
from one of these high street banks.
And I would be interested in
buying their best securitized mortgage,
their best customer mortgages.
So very, very low risk and dependable reliable payments.
And that’s what securitization basically does;
it transforms those illiquid assets
into marketable instruments.
As the pension fund manager,
I would receive the benefit from holding those mortgages.
Anything can be securitized.
Any private debt; it can be,
it can be credit cards, and it can be consumer loans.
There was a very big appetite for
securitized assets before the credit crunch
and this was one of the main drivers of the downfall
or crash in the mortgage market
because there was this cycle of more and more mortgages
being securitized, re-packaged and sold on
and this generated more and more appetite or demand
for these types of product
because they seemed to be quite safe and
generate very high or very reliable returns.
As a result,
banks wanted to feed this appetite and
wrote more and more of these mortgages
and make more money.
But then they began to be less careful about the funds
they were lending and began to write
what’s called sub-prime mortgages and
lent money to people who could not necessarily afford them.
And we talk about this later on
in the module about the cause of the credit crisis
but this was one of the main contributors of
the credit crisis being securitization.
There are various advantages as well as
some disadvantages of financial innovation.
Innovation has been a core topic for scholars,
because of its important contribution to economic growth
and to the stability of financial systems.
New financial products,
such as the securitisation of assets,
were believed to have tremendous potential for
the diversification and efficient management of risk.
The financial crisis that started in 2007 changed those beliefs,
as excessive risk-taking in some specialized innovating products
brought down the financial system and produced the deepest
and most prolonged economic crisis since the Great Depression.
Recent studies now blame
excessive growth of the financial economy
as detrimental to the growth of the real economy.
Innovation is a double-edged sword:
the right kind of innovation and favourable conditions
that may spur banks to invest in new technologies
would help the financial system fulfil its functions and,
as a consequence, deliver growth;
but too much innovation or
innovation that is not properly used,
can have serious consequences for the overall economy.
When we look at the Financial Crisis of 2007-2008,
as an example, we see that
it was associated with substantial financial innovations.
Banks substantially increased their securitization of loans.
Instead of issuing plain-vanilla securities
based on the loans’ cash flows,
some of the securities created were tranched securities
with the tranches having different rights
to cash flows and credit ratings.
In addition,
credit default swaps became important
derivative securities for transferring credit risk.
While these securities can transfer credit risk
that exists for other reasons
such as an underlying loan,
credit default swaps also can be used to
lay off or assume credit risk
that has not arisen in the course of other business.
Many blamed the financial crisis partly on these securities.
In response to it,
many argue that regulators should actively discourage complexity.
Accordingly,
regulators advocated improving access to simple, transparent products
so that there is always an easy-to-understand option for
consumers who are not looking for potentially complex or
sophisticated products.
So up to now on this chapter
we have looked at
the decline and concentration in banking and
the changes to the competitive landscape over time.
We have also looked at the trends in bank profitability, and costs
and we’ve looked also at
what the UK government has done to
try to influence more and more competition
within the UK banking industry.
The shortcomings that it found
as a consequence of the Cruikshank report and
the related recommendations.
We have also looked at examples of new financial innovation
and the drivers of financial innovation.
So this now concludes this chapter.
Thank you.