WEF FS RethinkingFinancialInnovation Report 2012

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Rethinking FinancialInnovation

Reducing Negative OutcomesWhile Retaining The Benets

A World Economic Forum report in collaboration with Oliver Wyman


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The inormation in this report, or upon which this report is based,has been obtained rom sources the authors believe to be reliableand accurate. However, it has not been independently veried andno representation or warranty, express or implied, is made as to the

accuracy or completeness o any inormation contained in this reportobtained rom third parties. Readers are cautioned not to placeundue reliance on these statements. The World Economic Forumand its project advisers, Oliver Wyman and Cliord Chance LLP,undertake no obligation to publicly revise or update any statements,whether as a result o new inormation, uture events or otherwise,and they shall in no event be liable or any loss or damage arising inconnection with the use o the inormation in this report.

The views expressed in this publication have been based onworkshops, interviews and research, and do not necessarily refectthose o the World Economic Forum.

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2012 World Economic ForumAll rights reserved.

No part o this publication may be reproduced or transmitted in anyorm or by any means, including photocopying and recording, or byany inormation storage and retrieval system.


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1Rethinking Financial Innovation

Contents

1 Contents

2 Tables

3 Preace

4 Steering committee members4 Working group members

4 Additional external contributors

4 Project team

4 Disclaimer

5 Letter rom the Steering Committee

6 Executive summary

9 Introduction The project journey

10 Part I: Recognizing and appreciating nancial innovation

11 1. The Importance o Innovation

12 1.1 What is innovation?

13 1.2 Degrees o innovation

14 1.3 The role o innovation in the economy

16 2. Focusing on Financial Innovation

16 2.1 Dening nancial innovation and its benets

16 2.2 Benets o nancial innovation

20 2.3 Understanding the particular qualities o nancialinnovation

24 3. The Role o Financial Innovations in the Financial Crisis

24 3.1 Introduction

26 3.2 Mortgage Backed Securities (MBS)

27 3.3 Collateralized Debt Obligations (CDOs)

29 3.4 Credit Deault Swaps (CDSs)

31 3.5 Structured Investment Vehicles (SIVs)

32 4. The Continuing Importance o Financial Innovation

32 4.1 Financial innovation in the post-crisis world:re-opening Pandoras Box?

33 4.2 Where nancial innovation creates value our keyopportunities or the uture

37 5. Conclusion

38 Part II: Reducing negative outcomes

39 6. Structuring a Solution

39 6.1 The negative outcomes to be avoided

41 6.2 The innovation process disentangled

42 6.3 Innovation process three discrete stages

43 6.4 Stakeholder groups

44 7. Recommendations 45 7.1 Review and adapt your Enterprise Risk

Management (ERM) ramework to address theincremental risks and uncertainties introduced bynancial innovation

50 7.2 Revisit New Product Approval (NPA) processes toproperly address the idiosyncrasies o nancialinnovation

52 7.3 Redesign incentives to provide the right motivation

54 7.4 Recommit and reocus innovation eorts to becustomer oriented

57 7.5 Acknowledge the importance o innovation and itsrole in a competitive, ree-market structure (and thus in

pro-competition regulation) 58 7.6 Strengthen systemic risk oversight in light o the

incremental risks and uncertainties introduced bynancial innovation

59 7.7 Collaborate with the industry to monitor andoversee its eorts in managing innovation risks to drivesustainable nancial innovation

60 Part III: What experts have to say

61 8. Kirsten Apple: Business Method Patents: DebunkingThree Myths

63 9. Thomas Deinet: The investment sector and capitalmarkets are the best breeding ground or nancial innovation

64 10. Daniel Homann: A Systemic Perspective on Innovationin Insurance

65 11. Josh Lerner: How Might Patenting Trends ReshapeFinancial Services?

66 12. Alexander Ljungqvist: Disruptive Innovation: Are StockExchanges Under Threat?

67 13. Margaret Miller: Financial Literacy and Capability andFinancial Innovation

69 14. Bill Shew: Innovation in Pharma and Lessons orFinancial Services

71 15. Piyush Tantia: Behavioural Economics and ConsumerProtection

72 16. Jennier Tescher: Sel- Regulation and Consumer Trust

73 17. Peter Tuano: Leveraging Financial Innovation to Servethe Poor

74 18. Tim Wyles: The Agency Problem in Consumer FinancialServices

76 Appendix

76 1. Historical Background to Selected Financial Innovations

76 1.1 MBS

76 1.2 CDOs

78 2. The FSB Principles or Sound Compensation Practices

80 Acknowledgements

82 Reerences

86 Endnotes


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2 Rethinking Financial Innovation

Table o Quotes

14 Quote 1: Josh Lerner, Jacob H. Schi Proessor o InvestmentBanking, Harvard Business School

14 Quote 2: Bill Shew, Partner, Oliver Wyman

15 Quote 3: Josh Lerner, Jacob H. Schi Proessor o InvestmentBanking, Harvard Business School

15 Quote 4: Kirsten Apple, Primary Examiner 3694 on specialassignment in the Oce o Chie Economist, USPTO

16 Quote 5: Kirsten Apple, Primary Examiner 3694 on specialassignment in the Oce o Chie Economist, USPTO

18 Quote 6: Alexander Ljungqvist, Ira Rennert Proessor o Finance,NYU Stern School o Business

20 Quote 7: Piyush Tantia, Executive Director, ideas42

21 Quote 8: Margaret Miller, Senior Economist, Financial InclusionGlobal Practice, World Bank Group

25 Quote 9: Thomas Deinet, Executive Director, Hedge FundStandards Board

27 Quote 10: Tim Wyles, Partner, Oliver Wyman Financial Services

32 Quote 11: Peter Tuano, Peter Moores Dean and Proessor oFinance; Sad Business School, University o Oxord

34 Quote 12: Peter Tuano, Peter Moores Dean and Proessor oFinance; Sad Business School, University o Oxord

36 Quote 13: Piyush Tantia, Executive Director, ideas42

39 Quote 14: Margaret Miller, Senior Economist, Financial InclusionGlobal Practice, World Bank Group

41 Quote 15: Alexander Ljungqvist, Ira Rennert Proessor o Finance,NYU Stern School o Business

43 Quote 16: Daniel Homann, Economic Counsellor, InternationalAssociation o Insurance Supervisors

44 Quote 17: Thomas Deinet, Executive Director, Hedge FundStandards Board

46 Quote 18: Jennier Tescher, President and CEO, Center orFinancial Services Innovation

50 Quote 19: Bill Shew, Partner, Oliver Wyman

55 Quote 20: Tim Wyles, Partner, Oliver Wyman Financial Services

57 Quote 21: Daniel Homann, Economic Counsellor, InternationalAssociation o Insurance Supervisors

58 Quote 22: Jennier Tescher, President and CEO, Center orFinancial Services Innovation

Table o Tables

16 Table 1: Functions o Financial Innovation Dened by Merton1995

17 Table 2: Examples o Financial Innovation over the Centuries

18 Table 3: Functions o Financial Innovation Dened by Tuano 2003

19 Table 4: Examples o Financial Innovations and Their Benets

62 Table 5: Top Financial Services Firms and Business MethodsPatents

Table o Callouts

9 Callout 1: Project Objective

11 Callout 2: Selected Quotes on the Importance o Innovation

11 Callout 3: The Importance o Innovation Organisation orEconomic Co-operation and Development (OECD) Business andIndustry Committee (BIAC)

12 Callout 4: Four Types o Innovation The OECDs Oslo Manual16 Callout 5: Dening Financial Innovation Lerner and Tuano

19 Callout 6: Assessing and Quantiying the Benets o FinancialInnovation

22 Callout 7: Knightian Uncertainty

22 Callout 8: Increased Uncertainty in Financial Innovation

23 Callout 9: Uncertainty and the Financial Crisis

25 Callout 10: Structured Finance Dening Terms

28 Callout 11: Regulatory Arbitrage and Financial Innovation

32 Callout 12: Post-crisis Attitudes to Financial Innovation ExampleStatements

35 Callout 13: M-PESA

42 Callout 14: The Three Pillars o Success or Innovation

50 Callout 15: Regulatory Requirements or the New ProductApproval Process

52 Callout 16: Incentive Misalignment and the Financial Crisis

Table o Figures

13 Figure 1: Innovation Horizons

24 Figure 2: How the Banking Crisis Evolved

26 Figure 3: US Outstanding Mortgage Debt by Securitization

27 Figure 4: Global CDO Issuance

29 Figure 5: Outstanding CDSs 2001-2011

34 Figure 6: Number o Uninsured and Uninsured Rate in the UnitedStates: 1987 to 2010

35 Figure 7: Global Micro-nance Overview

41 Figure 8: A Framework Approach

42 Figure 9: The Innovation Process

63 Figure 10: Capital Markets in the EU and the US

69 Figure 11: Two Eras o R&D Productivity in Pharma

69 Figure 12: Industry R&D Productivity Has Dropped in Pharma

77 Figure 13: CDO Structure Based on MBS


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Since the recent nancial crisis, a typical reaction to any mention o nancial innovation hasbeen: Did nancial innovation not cause this crisis? or Does the world really need urthernancial innovation? While many academic studies have conrmed the benets o nancialinnovation and its importance to the development o nancial systems, there is no doubt thatsome innovations in nancial services mutated rom their original purpose and contributed tothe crisis.

Therein lies a conundrum: on the one hand, nancial innovation is broadly benecial and isneeded to address many o societys challenges; on the other, negative outcomesassociated with nancial innovation are too serious to ignore.

In this spirit, the chie executive ocers o many o the worlds leading nancial institutions,among those committed to the World Economic Forums Industry Partnership programme,came together in late 2010 to endorse a new initiative tasked with exploring this issue and toaddress such questions as:

Why is nancial innovation needed?

How can nancial innovation be improved to better emphasize the positive outcomes

and reduce the risk o adverse consequences? How can nancial innovation be strengthened to better serve societys needs and

economic development?

What does the enabling ramework that allows positive nancial innovation to fourishlook like?

To answer these questions, or the past year a World Economic Forum team has workedwith many constituents and with the active support o Oliver Wyman to analyse the relevantliterature and seek the counsel o over 100 businesses, and political and academic leadersaround the globe. The project was conducted under the stewardship o a SteeringCommittee, chaired by Stean Lippe, the ormer Group CEO o Swiss Re, supported by aWorking Group o senior industry executives, regulators and academics who guided itswork.

The projects ndings converge on a core theme, namely that the most important aspect oinnovation, in the context o risk, is that there are no historical metrics to determine its impacton the world. Thereore, the industry needs to pay special attention to the ways in which itsmechanisms or assessing and managing risk should be adapted to take better account oinnovations. Another important nding is that the post-launch management o an innovation,including downstream variants and new applications, is more relevant, in many cases, thanthe original innovation itsel. In this respect, this project is very much in line with and relevantto the theme o the World Economic Forum Annual Meeting 2012 The GreatTransormation: Shaping New Models. As well as capturing the current economic andgeopolitical situation, that theme also looks to ensure that our uture is one o inspiredcollaboration and bold solutions to the global, regional and industry challenges and not areturn to the status quo.

On behal o the World Economic Forum, I wish to thank all who have contributed their time

and expertise to this report, particularly the Steering Committee, the Working Group and theinterview and workshop participants, Senior Project Manager Isabella Reuttner, and ourpartners at Oliver Wyman, in particular Peter Carroll and Dominik Weh.

We trust you will nd this report to be a helpul reerence to understand the broad challengesthat must be tackled to ensure that society continues to benet rom nancial innovation.

Preace

Giancarlo Bruno

Senior Director andHead o the FinancialServices IndustryWorld Economic

Forum USA


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Additional External Contributors

Apple, Kirsten; Primary Examiner 3694 on special assignment inthe Oce o Chie Economist; USPTO

Lerner, Josh; Jacob H. Schi Proessor o Investment Banking;Harvard Business School

Schuermann, Til; Partner; Oliver Wyman

Shew, Bill; Partner; Oliver Wyman

Tantia, Piyush; Executive Director; ideas42

Tuano, Peter; Peter Moores Dean and Proessor o Finance;Sad Business School, University o Oxord

Wyles, Tim; Partner; Oliver Wyman

Project Team

Carroll, Peter; Partner; Oliver Wyman

Reuttner, Isabella; Senior Project Manager; World EconomicForum

Weh, Dominik; Manager; Oliver Wyman

Thanks go to Ann Brady, Rob Jameson, Kamal Kimaoui and JamieWhyte or their editing and layout work.

Disclaimer

The members o the Steering Committee and the Working Groupsupport the recommendations and views expressed in this report.However, they do not all necessarily agree on every detailed pointmade herein. The opinions expressed are o a personal nature anddo not necessarily refect the stance o the organizationsrepresented by the Steering Committee and Working Groupmembers.

Steering Committee Members

Allen, Ben; Chie Innovation Ocer; Marsh & McLennanCompanies

Bruno, Giancarlo; Head o Financial Services; World EconomicForum

Hayord, Michael; Chie Financial Ocer; FIS

Hopkins, Deborah; Chie Innovation Ocer; Citi

Kochhar, Chanda; Chie Executive Ocer; ICICI

Lippe, Stean; ormer Chie Executive Ocer; Swiss Re (Chair othe Steering Committee)

Macnee, Walt; President, International Markets; MasterCard

McDonald, Scott; Managing Partner; Oliver Wyman

Reyes, Cecilia; Group Chie Investment Ocer; Zurich FinancialServices

Ward, Richard; Chie Executive Ocer; Lloyds o London

Working Group Members

Banerjee, Anindya; Chie Strategist; ICICI

Bies, Susan; Independent Director

Brackeen, Debra; Managing Director, Head o StrategicAlliances; Citi

Deinet, Thomas; Executive Director; Hedge Fund StandardsBoard

Graham, Dr. Stuart; Chie Economist; United States Patent andTrademark Oce (USPTO)

Hamilton, Christopher; Head o Strategy; Capco-FIS

Hedrick-Wong, Yuwa; Global Economic Advisor; MasterCard Homann, Daniel; Economic Counsellor; International

Association o Insurance Supervisors (IAIS)

Karl, Kurt; Chie Economist; Swiss Re

Ljungqvist, Alexander; Ira Rennert Proessor o Finance, NYU;Stern School o Business

Miller, Guy; Managing Director and Chie Market Strategist;Zurich Financial Services

Miller, Margaret; Senior Economist, Financial Inclusion GlobalPractice, World Bank Group

Steele, Gavin; Secretary to the Council and the Franchise Board;Lloyds

Tescher, Jennier; President and CEO; Center or FinancialServices Innovation


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Dear Reader,

Financial innovation is not a new phenomenon. Modern banking originated in 14th-centuryFlorence and modern insurance can be traced to Lloyds Coee House in 17th-century

London. Reinsurance is one o the oldest innovations in the insurance sector. These andthousands o subsequent innovations continue to provide valuable nancial unctions,undamental to a thriving economy.

Nevertheless, the 2008 nancial crisis revealed that nancial innovation can sometimes havenegative consequences. Complex, synthetic securities that relate to poorly underwrittenmortgages are an example.

The objective o this report is to highlight ways to improve the management o nancialinnovation. We want nancial innovation to continue to develop products and services thatwill benet society and drive economic development. At the same time, we seek to reducethe chances o unintended negative outcomes.

The report takes the position that the primary responsibility or improving the management

o nancial innovation lies with banks and insurers. It provides a taxonomy o potentialnegative outcomes and recommends initiatives or companies, industry bodies andregulators. For institutions, it recommends improvements to existing enterprise riskmanagement techniques, new product impact assessments, better design o incentives,and enhanced consumer orientation. We believe these changes can materially reduce theodds o unintended negative consequences rom innovation. We also believe that industrygroups can help oster and promote positive nancial innovation to better serve societal andeconomic needs. Finally, we provide guidance to regulators on the best use o their limitedresources, highlighting the ways in which they can allow nancial innovation to fourish whilereducing the risks or which they have primary oversight responsibility.

O course, we acknowledge that many eorts in this area are already under way. Manyregulatory reorms have been proposed and some enacted that will have an eect oninnovation.

Ultimately, our goal is to create a saer environment in which nancial innovation will continueto fourish. Due to ongoing reorms, we remain concerned that new laws or regulations couldorbid or inhibit innovation in nancial services. Through our recommendations we hope tobuild a more resilient nancial system which is less prone to innovations with unintendednegative consequences and to encourage dialogue among stakeholders nancial sectorbusinesses, regulators, industry bodies, consumers and non-nancial institutions.

The Steering Committee and the Working Group would like to thank those individuals whogenerously gave their time to support this project. We hope that all will nd our report asstimulating to read as we ound it to research, debate and write.

Stean Lippe

Steering CommitteeChair, Swiss Re

Letter rom the Steering Committee


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Financial innovation has a long history o success, delivering benets that are widely elt inthe industry and across the broader economy. Recently, however, some nancial innovationshave not been viewed so avourably. This report acknowledges that some nancialinnovations were centrally involved in the events leading up to the nancial crisis and ensuingrecession. Indeed, the project was commissioned to examine innovation in nancial servicesin order to understand how or why it may sometimes contribute to negative outcomes. Theobjective was to provide recommendations that could allow the industry to reduce the uturelikelihood o such negative outcomes rom innovation.

For perspective, the project examined the innovation experiences o other, non-nancialindustries. Unsurprisingly, it ound recurring patterns o success and occasional ailure, andnot only commercial ailure but patterns o negative outcomes. In act, in many industriesthe term negative outcomes can even include atalities. One need only look at thepharmaceutical industry to see occasional unintended side eects that may include seriouspersonal harm.

It might be comorting to think that the nancial services sector is not alone in acing thesetypes o innovation-related challenges. However, while nancial services must generally deal

with non-atal risks, the challenge is still critical since the high degree o interconnectednessbetween nancial services and the rest o the economy makes it, i not unique (the utilitiessector is similar) then at least, distinctive. Successul innovation in nancial services canimprove capital productivity with benecial eects that permeate through the widereconomy. Unsuccessul innovation can have the opposite eect. It is important, thereore, toace up to the challenge eectively.

Whether one ocuses on extremely damaging unintended outcomes or on lesser ones, areview o other sectors also demonstrates that essentially every industry has some type ogovernance mechanism that attempts to channel innovation so that society as a whole canenjoy the benets while exposure to negative outcomes is reduced.

The governance mechanisms in nancial services include extensive risk managementprocesses that have been developed over the past decades. Initially ocused on credit and

interest rate risk, in banking, and on actuarial risk in insurance, the risk managementrameworks in nancial services have gradually extended their scope to address myriadadditional categories o risk, including reputational risk, event risk, operational risk andothers. Aside rom explicit risk-management rameworks, governance mechanisms alsoinclude new product development and approval processes employing various saeguardsagainst unwise innovation. And o course they include an extensive regulatory inrastructurethat has been in place since beore the crisis and is already being amended and extended asa result o it.

Executive summary


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An important nding o this project is that a great deal o the existing governance rameworkor risk management, while relevant to the particular challenges o innovation, are applicableto the measurement and management o all risks, including those associated withestablished products. A corollary is that most o the recommendations associated withinnovation and its potential or generating negative outcomes are likely to be suggestions oradapting and improving existing governance mechanisms. Another way to state this ndingis that concerns over innovation outcomes do not require an entirely new innovationgovernance ramework, but enhancements to existing ones. And that is the pattern o thisreports recommendations.

Another important nding is that negative outcomes cannot reliably be predicted orindividual innovations. Examining actual innovations and ocusing upon those requentlycited or their contributory role in the crisis are inconclusive. While certain actors appear torecur, there is no obvious combination o dening characteristics or an innovation thatpredicts negative outcomes. Among the actors that recur, one can cite complexity, leverageor embedded leverage, and the alignment o incentives. Yet, while these may be associatedwith some cases o negative outcomes, they are not always. At best, these actors may, insome combination, signal the need or a higher level o attention to possible uture concerns.

This leads to a third nding: it is important to recognize that innovation leads to situations orwhich there is no history. It introduces Knightian uncertainty, making its impact in someways unmeasurable. This is easiest to demonstrate in the context o a new product beingintroduced to the marketplace. Any attempt to anticipate its uture perormance runs intovarious diculties. I the product is unequivocally original, there will be no empirical evidenceto support estimates o its perormance or its eect in the marketplace. I the product isinnovative but seems similar to a pre-existing one, or could be considered a variant oanother, it will be tempting to use available empirical data to rame some estimates o thelikely perormance o the new one. And this may be even more risky, or the assessment willseem to be in sample when it is really out-o-sample, promoting a alse sense ocondence. While it may be relatively easy to recognize an innovation as it emerges rom anestablished new-product development process, it may be signicantly harder to correctlyidentiy innovative adaptations, which are a eature o the nancial world.

Another way innovation introduces Knightian uncertainty is through the unpredictability ocustomers responses to the innovation and, in a broader sense, o unoreseeable rippleeects through the wider economy. And again, where one may be tempted to seekanalogies rom prior responses to similar or similar-seeming products, an innovation alwayscalls into question the relevance o the analogy.

Pulling together these threads, this report nds that:

Innovation is a broadly positive orce within nancial services.

Innovation, by denition, introduces Knightian uncertainty to nancial services.

This uncertainty occasionally maniests itsel in negative outcomes.

The nancial services sectors relationship to the rest o the economy makes it vital toreduce the likelihood o negative outcomes.

The best way to reduce this likelihood is by adapting existing risk managementmechanisms so they are more sensitive to the specic contribution o innovation touncertainty and risk.


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The report makes recommendations to banks and insurers, some o which could also beadopted by industry bodies. The authors are aware that many o these recommendationshave either already been implemented or are currently being implemented by a bank, insurer,reinsurer or regulator somewhere within the industry. However, not all o them are ullyimplemented everywhere. Taken as a group, the recommendations can be thought o as anaspirational set o best practices related to risk management and innovation. Therecommendations to industry participants all into our areas:

i) Enterprise risk management: a careul step-by-step re-evaluation o the ways risks arecounted, measured and managed, with the necessary emphasis on the ways innovationis unique and has unmeasurable consequences.

ii) New product development and approval processes: again, a careul step-by-stepreassessment o existing processes to be sure that innovation-specic dimensions areaddressed. Particular stress needs to be placed upon the identication o productversions or adaptations that may not appear to be innovations but are, because theymove the rms experience out-o-sample.

iii) Incentive design and implementation: reassessment and redesign to address theparticular challenges o valuation, risk assessment and timing in calculating and payingcompensation related to innovation.

iv) Consumer orientation: recommitment to consumer-riendly principles o product andbusiness process design to steer innovation in a direction that will regain customer trustand create a better alignment o interests between the bank or insurer and its customers.

The report also makes recommendations to regulators, ocusing on three areas:

i) Building a pro-competitive marketplace: ollow a handul o basic principles to do noharm, use the lightest touch and preer market solutions to make rules that allowcompetition to oster innovation and help distribute its benets broadly within the industryand throughout the economy.

ii) Strengthening systemic risk oversight: accept the challenge that comes with the uniquerole o the regulator, to unravel the drivers o systemic risk, monitor them and act toreduce situations or activities stemming rom innovation that increase such risk.

iii) Monitoring and overseeing the industry: support and extend the industrys eorts toimprove its primary innovation eorts as well as to rene its related management andoversight eorts o the uncertainties introduced by innovation.

This project has concluded that innovation in nancial services is broadly benecial, bothwithin the industry and throughout the wider economy. It has also concluded that nancialinnovation introduces a type o uncertainty that may sometimes go unrecognized andgenerates negative outcomes. By making recommendations that can improve the industrysanticipation and management o these negative outcomes, it is the intent o the report andits ervent hope that the industry will continue to be granted the latitude and enjoy thesel-condence to pursue innovation as a path to individual prot, to industry prot and towide societal benets.


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In light o much nancial services innovation having gone o track, particularly in the run upto the start o the 2007 nancial crisis, the project goal centred on reducing the chances onegative outcomes rom nancial innovation in a way that would not reduce the positivebenets o innovations. At the end o our journey, we believe this balanced goal is achievable.

The nancial services industry has come to be characterized by a high degree o oversightthrough multiple levels o regulation and the application o increasingly sophisticated riskmanagement rameworks, tools and processes. Our recommendations thereore ocus inlarge part upon the ways in which these risk management processes can be improved toshed light on the potential unintended consequence that may accompany nancial innovation.These risk management mechanisms are themselves already being revised and improved totake account o the wider lessons rom the nancial crisis.

In the wake o the nancial crisis, with many decrying the role o nancial innovation as acontributor to the crisis and the ensuing recession, we elt we must candidly acknowledgethat certain nancial innovations did play a contributory role in the crisis, even though theseinnovations may only deserve a share o the blame.

Furthermore, we noted that the probabilistic nature o nancial innovation outcomes thelimited ability to know with certainty what would result rom any particular innovation madeany assessment o innovation similar in nature to the assessment o all risks, not just theidiosyncrasies o innovation which we dene later on in Chapter 2.3. This led us to twointermediate conclusions. One is that the techniques, methods and processes by which ourindustry manages risk can be adapted to manage these idiosyncrasies. We did not need todene a new innovation governance ramework so much as to dene the ways in whichexisting risk management rameworks can be enhanced to capture innovationidiosyncrasies. Second, ollowing rom the rst, we needed to pinpoint precisely what it isabout innovation that changes or increases risk. The broad answer to that is that innovation,because it does not have a track record o perormance, creates uncertainty about utureoutcomes and it does so in several dierent ways.

This report is organized in three main parts, the rst o which looks at how nancial

innovation is dened, its importance to society, the benets o nancial innovation and thecounterbalancing role o innovation in the recent nancial crisis, as well as the uture role ornancial innovation in helping society address undamental problems. The second part othe report builds a ramework or our recommendations and then outlines and discussesthese in some depth. The nal supporting part o the report oers analyses rom industryexperts on key topics related to the reports recommendations, and also ranges urtheraeld to consider issues such as patent protection in nancial services, the misalignment oincentives and the case or industry sel-regulation.

The Project Team

Introduction - The Project Journey

Callout 1: Project Objective

The goal o this project, RethinkingFinancial Innovation, is to promote andstrengthen the societal and institutionalramework that enables nancial innovationto fourish.

Stean Lippe, ormer CEO o Swiss Re and Chair o the Steering

Committee


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Part I:Recognizing AndAppreciatingFinancialInnovation


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Part I: Recognizing And Appreciating Financial Innovation

Innovation is recognized as the critical source o economic growthand o improvements in social welare. It is given much o the creditor the rise in living standards since the 18th century and policy-makers, almost universally, see innovation as a vital lever or creatingemployment and raising productivity. Callout 2 oers typicalstatements o how dependent the world eels on the power oinnovation.

These are not only words. Recognizing the way in which innovationsupports economic growth, many governments around the worldencourage investment in research and development by allowingcompanies to claim tax credits or the amount spent on it,particularly or technology-driven innovations.1

The power o innovation derives rom its combination withinvestment and competition. Innovation initially benets the innovatorand investment magnies the returns. Competition then helps todistribute the benets o innovation more widely across society,

driving down prices and making new products and services widelyavailable. Some innovations prove to be what are called generalpurpose technologies, dened in more detail in section 1.2, uponwhich a myriad o urther innovations can be built. Electricitygeneration is a 19th-century example o such an innovativewellspring, transistors and microchips are 20th-century examplesand the Internet is a modern one.

Perhaps the key thinker about the role o innovation within thecapitalist system is Joseph Schumpeter, the Austrian economist,who rst described the critical part played by entrepreneurialinnovation both in creating new ideas and in displacing establishedproducts, processes and industries:

The undamental impulse that sets and keeps the capitalist enginein motion comes rom the new consumer goods, the new methodso production or transportation, the new markets, the new orms oindustrial organization that capitalist enterprise creates. ... Thisprocess o Creative Destruction is the essential act aboutcapitalism.2

Innovation always changes the status quo, but some innovationscause greater disruption than others. In the most severe cases,radical innovations undamentally change society and spawn urthergenerations o innovation.

At the other end o the spectrum, incremental innovations help todierentiate a company rom its competitors and, or the consumer,oer a constant round o useul improvements to existing products,

processes and services, as well as to reductions in real prices.

1 The Importance o Innovation

Today, more than ever beore, innovation,enterprise and intellectual assets driveeconomic growth and increase standards oliving. Innovation is instrumental in creatingnew jobs, providing higher incomes, oeringinvestment opportunities, solving socialproblems, curing disease, saeguarding theenvironment and protecting our security. To

help achieve these objectives, governmentsmust create appropriate incentives orcontinued growth in innovation andtechnology development and embracesound policies or assuring broad socialdiusion and access to key scientic andtechnological advances that enable us, asNewton rst observed, to stand on theshoulders o geniuses.

Source: OECD (2003) Creativity, Innovation and Economic

Growth in the 21st Century. Business and Industry Advisory

Committee to the OECD

Innovation is thespecic instrument

o entrepreneurship the act that

endows resourceswith a new capacity

to create wealth.Peter Drucker

Innovation is thevital spark o allhuman change,

improvement and

progress.Theodore Levitt

Innovation is thecentral issue in

economicprosperity.

Michael Porter

Callout 2: Selected

Quotes on the

Importance o

Innovation

Callout 3: The Importance o Innovation

Organisation or Economic Co-

operation and Development (OECD)

Business and Industry Committee (BIAC)


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1.1 What is Innovation?

In the public mind, innovation is oten thought o in terms orevolutionary new physical products or a new technology. However,

innovation is clearly a much wider phenomenon, seen across manydimensions o economic lie, including manuacturing and otherbusiness processes, as well as new business and organizationalmodels.

For example, the Model T Ford, launched in 1908, is clearly aninnovative product in itsel. But Henry Fords most radical innovationwas actually the assembly line actory that built the car usingrevolutionary working processes. In modern industries, innovationcan be as much about new approaches to design, business modelsand global supply networks as about innovation in tangible products.

This wider denition o innovation is commonly accepted byeconomists and is set out in the Oslo Manual o the OECD, a key

cross-industry publication that oers standards and guidelines ormeasuring technological, product and process innovation.

The manual identies the our types o innovation described inCallout 4:

i. Product innovation

ii. Process innovation

iii. Marketing innovation

iv. Organizational innovation

Importantly, in relation to the ocus on nancial services, themanuals denition embraces innovative services as well as physical

products and technologies, and includes signicant improvementsto existing products and services as well as truly revolutionary ideas.

This report adopts the manuals wide denition and uses it as aplatorm or the more precise denition o nancial servicesinnovation discussed in section 2.

Callout 4: Four Types o Innovation The OECDs Oslo Manual

A product innovation is the introduction o a good or servicethat is new or signicantly improved with respect to itscharacteristics or intended uses. This includes signicantimprovements in technical specications, components andmaterials, incorporated sotware, user riendliness or otherunctional characteristics. Product innovations can utilise newknowledge or technologies, or can be based on new uses orcombinations o existing knowledge or technologies. The termproduct is used to cover both goods and services. []

A process innovation is the implementation o a new or

signicantly improved production or delivery method. Thisincludes signicant changes in techniques, equipment and/orsotware. Process innovations can be intended to decrease unitcosts o production or delivery, to increase quality, or toproduce or deliver new or signicantly improved products. []

A marketing innovation is the implementation o a newmarketing method involving signicant changes in productdesign or packaging, product placement, product promotion orpricing. Marketing innovations are aimed at better addressingcustomer needs, opening up new markets, or newly positioninga rms product on the market, with the objective o increasingthe rms sales. []

An organizational innovation is the implementation o a new

organizational method in the rms business practices,workplace organization or external relations. Organizationalinnovations can be intended to increase a rms perormanceby reducing administrative costs or transaction costs, improvingworkplace satisaction (and thus labour productivity), gainingaccess to non-tradable assets (such as non-codied externalknowledge) or reducing costs o supplies. []

Source: OECD. (2005) Oslo Manual, Guidelines or Collecting and Interpreting Innovation Data. 3rd

edition. Paris: OECD Publishing. pp. 47-52


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1.2 Degrees o Innovation

History shows that innovations vary hugely in terms o the size andnature o their eect, which may be proound or relatively trivial.

Innovations also vary in terms o how revolutionary they are inrelation to existing technologies or existing approaches to therelevant market.

One useul way o thinking about this can be ound in the concept oinnovation horizons recently introduced by Christian Terwiesch andKarl Ulrich.3 Under this approach, most innovations ace two typeso uncertainty technological uncertainty and market uncertainty.The specic degree o uncertainty along each o these dimensionscharacterizes the innovation and hints at whether the eect o theinnovation is likely to be incremental or radical.

A radical innovation is dened as an innovation that signicantlydisrupts the market into which it is born. This disruption has costs

attached to it but these are generally outweighed by the long-termbenets. Importantly, the benets largely accrue to the innovator andthe consumer o the product, and the costs accrue to establishedmarket suppliers.

This is the phenomenon captured in Schumpeters phrase creativedestruction, which acknowledges the erosion o value thatestablished companies experience when another companyintroduces a radical innovation.4 However, this temporary eect iscounterbalanced by the innovations eventual contribution towardssustainable, long-term economic growth.5

For example, i the innovating company already has access to thetechnology underlying the innovation, the level o technologicaluncertainty is low. The uncertainty rises i the technology exists, butis outside the rms control and experience, and becomes very highi the innovation depends on an entirely new discovery.

Likewise, an innovation that caters to a rms existing customers hasa low level o marketing uncertainty, compared to an innovationaimed at customer segments served by other rms or, at theextreme, customer segments that have not yet been identied andtargeted in the marketplace.6

Each innovation can be characterized in line with the horizon itoccupies with respect to these two dimensions. For example, theinnovations within Horizon 1 o Figure 1 are clearly incremental andaccount or most o the innovations, by number, seen in the worldaround us. Incremental innovation helps to ensure a healthymarketplace as companies compete to improve their existingproducts, services and ways o doing things. This kind o innovationmight be sourced within the rm using either traditional methods or,increasingly, crowd sourcing techniques to elicit ideas romemployees, such as that employed by Toyota.

By contrast, Horizon 2 innovations make use o technology andmarkets that are known but exist outside the rm, while Horizon 3innovations are the kind o revolutionary leaps that the R&D labs omajor companies dream about. In the case o historys truly radicalinnovations rom the steam engine to the Internet neither themarket or the product, nor the enabling technology existed beorethe vital period o innovation. Radical innovations are positioned

here.

In some cases, an innovation not only has a radical, positive eecton a single area o economic lie but undamentally changes theeconomy. This kind o radical innovation, sometimes reerred to as ageneral purpose technology (GPT),7 has three key characteristics:

Pervasiveness across a broad range o sectors

Improvement over time as urther renements are made

Further innovations in the orm o novel products and processes.

By denition, all GPTs are disruptive because they undamentallychange the structure o the current marketplace. A trivial examplemight be the disruption to candle makers caused by electric lighting.

Figure 1: Innovation Horizons8

Knowledgeofmarket

Knowledge of technology

Horizon 1opportunities



New categoryproducts

Exploration intonew markets

Adjacentgrowth

Improvements,extensions, variantsand cost reductions

Next generationproducts

Exploration with newtechnologies

Newmarket

Existingmarket that

we do notserve

Existingmarket that

we currentlyserve

Existing technologythat we currently use/deploy

Existing technologythat we do not use/deploy

New technology

Source: Adapted rom Terwiesch, C. & Ulrich, K. (2009)


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1.3 The Role o Innovation in the Economy

1.3.1 Innovation, Competition and Investment A Complex

Relationship

The complex relationship between innovation, investment andcompetition is undamental to modern economies. Policies thataect one o the three tend to have unoreseen eects on the othersas well.

Without competition, or example, monopolists and oligopolists havear less incentive to innovate and introduce novel or improvedproducts and services. Competition is seen as so essential toinnovation that the US Department o Justice and the Federal TradeCommission cite worries about the potential negative eect uponinnovation in over a third o merger challenges.9

The history o the mobile phone illustrates why the relationship is so

important. The American Telephone and Telegraph Company (AT&T)held a virtual monopoly o the American communication market ormost o its 100-year existence beore it was orced to spin o partso its business in 1984. By eectively controlling the communicationsmarket, AT&T was able to determine the direction o the industryincluding the development o novel systems and inrastructure.Cellular telephones were developed in the United States by Bell Labs(a part o AT&T) as early as the 1940s and were used or a variety oniche purposes. However, AT&T did not believe there was a sucientmarket or cellular phones and invested relatively little in research,development and inrastructure.

Shortly ater the breakup o AT&T, Motorola released the rst widelyavailable mobile telephone. While AT&T had originally estimated that

the global mobile phone market would reach 1 million people by theyear 2000, instead the market grew to 740 million by that date.10

It is easy to dwell on the benets o successul innovation to theinnovator but this example perhaps shows that competition is atleast as strong a spur to innovation as the spoils o the upside.

I competition supports innovation, the reverse is also true. Withoutinnovation, much o the creative power o competition to supportsocietys goals is lost too. Imagine, or example, a pharmaceuticalsindustry where competition existed simply to make the productionand marketing o existing drugs more ecient.

Innovation in the pharmaceutical industry is essential or continuedimprovements in healthcare. However, drug development is aparticularly capital- and cash-intensive undertaking, as thecontribution by Bill Shew in Part III describes. Furthermore, the vastmajority o novel discoveries never go into production and thereorenever provide any revenue.

Quote 1: Josh Lerner, Jacob H. Schi

Proessor o Investment Banking,

Harvard Business School

The use o patent law toprotect intellectual property

has increased dramatically inUS nancial services over thelast decade or so, in response

to a general strengthening opatent protection as well ascourt rulings specic to the

nancial sector. The trend mayincrease the rate o innovation

in nancial services andchange the shape o the

industry.

(See Chapter 11 or the ull contribution)

Quote 2: Bill Shew, Partner, Oliver

Wyman

Innovation is the lieblood o

pharmaceutical companies,which typically spend in excess

o 15% o sales on R&Dannually. Pharmaceutical

companies have to continuallyreinvest in R&D to replenish

their product portolios toremain competitive and sustain

growth and protability.

(See Chapter 14 or ull contribution)



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This introduces a tension into the relationship between innovation,competition and investment. Only through patenting their discoveriescan pharmaceutical companies ensure that their investment inresearch and development will generate prots i and when they do,eventually, produce a successul product.

Patents allow companies to protect their research and developmentinterests by preventing competitors rom replicating or imitating theresulting innovation or a period o time, allowing the innovator torecover their investment and make an attractive prot.11 Without thesaeguard o patents, investment in innovation would be much lesstempting.12

Patents are, in eect, temporary monopolies. In history, kings andother rulers have granted such monopolies to avoured subjects ormore than 2,000 years. But it was 17th-century Europe thatintroduced the critical dimension o associating such grants withnew mechanisms and new inventions. This, in eect, is a

mechanism to protect innovations and to provide an incentive toinnovate as new ideas and techniques are typically disseminatedand then quickly copied. In such cases, the rm cannot capture allthe benets generated by its innovation, which lessens the incentiveto invest in innovation activities. For some innovation activities, theimitation cost is substantially lower than the development cost.

Thereore, society must continually balance the need to encourageinnovators by protecting the rewards rom their innovation, with theneed to avoid creating or perpetuating damaging monopolies.Getting this balance right is important not only or protectinginnovation, but also or protecting competition. Kirsten Applescontribution as well as Josh Lerners contribution in Part III take thisdiscussion a step urther by looking at the possible eect o the

recent strengthening o patent law on competition in US nancialservices.

More generally, the strong, complex, relationship betweeninnovation, investment and competition must be taken into accountby policy-makers when making decisions that could discourageproductive innovation.

Quote 3: Josh Lerner, Jacob H. Schi

Proessor o Investment Banking,

Harvard Business School

Financial services is not a newindustry, like biotech, in whichpatenting can play a key role indetermining the initial industrystructure. Instead, establishednancial institutions gainsubstantial benets rom theirbroad distribution networks.The creation o large patentportolios may only reinorce

this power.


Quote 4: Kirsten Apple, Primary

Examiner 3694 on special assignment in

the Oce o Chie Economist, USPTO

The recent Bilski versusKappos decision by the USSupreme Court validated thata business method is simplyone kind o method that is, atleast in some circumstances,eligible or patenting under101. These types o patent arenot a special exception togeneral practice, but insteadare commonly sought bycompanies both inside andoutside the nancial servicessector. Increasingly,companies throughout theeconomy are using thesepatents to protect theirinnovations and to supporttheir corporate strategies.




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2.2 Benets o Financial Innovation

2.2.1 Background The History o Financial Services Innovation

Generally speaking, i an industry exists or a long period o time, it isbecause it provides a valued service and has ostered a long series ouseul innovations that maintain its vitality. The nancial servicesindustry is no exception. Table 2 oers a brie chronology o importantinnovations rom the history o banking and insurance, which can berelated to the undamental unctions o nancial innovation and thenancial services sector in more general as set out in Table 1 above.

As the overview on historic nancial innovations in Table 2 makesclear, it would be dicult to pick any particular historical momentover the past centuries in which to declare that the nancial servicesare somehow complete and should cease to innovate. Fewcommentators on nancial innovation have argued the world wouldbe better without loans, car insurance or stock exchanges. (Otherthan Shakespeare: Neither a borrower nor a lender be.16)

Instead, the controversy over nancial innovation ocuses on morerecent innovations. This section thereore restricts discussion o thebenets o nancial innovation to the period ater the Second WorldWar and mainly ater 1960.

It is worth noting in passing that many o the historical examples onancial innovation listed in the timeline have at some point beenmisused and misapplied by market participants, and havecontributed to signicant nancial system disruptions. Over time,however, most have been accepted as benecial.

2.1 Dening Financial Innovation and its Benets

This report denes nancial innovation as the act o creating andthen popularizing new nancial instruments, technologies,

institutions, markets, processes and business models includingthe new application o existing ideas in a dierent market context.

This denition, drawn rom the source presented in Callout 5, isdeliberately wide. It includes innovations across the nancial world,whether their source is a regulated institution, a member o the widernancial community or shadow banking sector, or an individualinventor. However, no denition can quite capture the complexity oinnovation in nancial services where a single new product mightbring together innovative eatures in terms o unction, marketing andcustomer segment, and the supporting inrastructure.

The denition matters because this report will later recommendways in which nancial service rms and their regulators will need to

adapt traditional risk management and other processes to minimizethe potential unintended consequences associated with innovation.An important aspect o that adaptation will be recognizing theimplications o innovations that are not always obvious.

Another way to think about nancial innovation is in terms o itsunction. Economists say that the overall unction o nancialinnovation is to reduce nancial market imperections.

Innovations might help to ll a gap in the products or servicesavailable to consumers (e.g. by providing a new type o secure Webpayment mechanism) or to correct the imbalances o inormationavailable to contracting parties (e.g. through an innovative pricing orrisk estimation technology).13

They might also reduce market rictions, such as the high costs otransacting some products (e.g., illiquid securities such as equities innon-public companies), bring consumers together to oer themeconomies o scale or provide a novel way o communicating withpotential consumers or vendors through some kind o marketinginnovation.

Above all, perhaps, nancial innovation has introduced new ways orpeople to gain mutual advantage rom complementary needs, e.g.the desire to borrow money, raise investment capital, or oset a risk,on the one hand, and the desire to lend, invest money or assume arisk in exchange or a ee on the other.

There are various ways to categorize these attempts to perect theworlds nancial markets and Table 1 sets out one o the best

known. The table reminds us that, traditionally, economists havethought about innovation as a way to make nancial services moreuseul, transparent, accessible and ecient.

2 Focusing on Financial Innovation

Callout 5: Dening Financial Innovation Lerner and Tuano

Financial innovation is the act o creating and then popularizing newnancial instruments, as well as new nancial technologies,institutions and markets. The innovations are sometimes divided intoproduct or process variants, with product innovations exemplied bynew derivative contracts, new corporate securities or new orms opooled investment products, and process improvements typied bynew means o distributing securities, processing transactions orpricing transactions. In practice, even this innocuous dierentiation is

not clear, as process and product innovations are oten linked.Innovation includes the acts o invention and diusion, although inpoint o act these two are related as most nancial innovations areevolutionary adaptations o prior products.

Source: Lerner, J. & Tuano, P. (2011) The Consequences o Financial Innovation: A Counteractual

Research Agenda. Annual Review o Financial Economics, 3, pp. 6

Functions Examples14

To provide ways o clearing and settling payments to

acilitate trade

Credit and debit cards,

PayPal, stock exchanges

To provide mechanisms or the pooling o resources and orthe subdividing o shares in various enterprises

Mutual unds, securitization

To provide ways to transer economic resources throughtime, across borders and among industries

Savings accounts, loans

To provide ways o managing risk Insurance, many derivatives

To provide price inormation to help coordinate decentralizeddecision-making in various sectors o the economy

Contracting by venturecapital rms

To provide ways o dealing with the incentive problem createdwhen one party to a transaction has inormation that the otherparty does not or when one party acts as agent or another

Price signals, extractingdeault probabilities romcredit deault swaps (CDS)

Table 1: Functions o Financial Innovation Dened by Merton 199515


Quote 5: Kirsten Apple, Primary Examiner 3694 on special

assignment in the Oce o Chie Economist, USPTO

In conclusion, nancial services companies donot appear to be restricting themselves topatenting in the business-method subjects, andin act were patenting prior to the State Streetdecision. Many o these companies continue toinnovate in technologies, methods and serviceoerings, and approximately one-hal o the

patents they have sought over time are in eldsoutside o the business method patentclassication at the USPTO.



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Year Innovation Description

9000 BConwards

Medium o exchange Bartering o produce and cattle

5000 BC Shell money Spondylus shell s traded in south-easte rnEurope

4000 - 2500BC

Credit Mesopotamian tablets record ancient loans andinterest paid

2500 BC Insurance Babylonian goods transport insurance

1700 - 1100BC

Annuities (rst recorded) First purchased by Egyptian prince

1000 BC Metal money and coins Ear ly Chinese tool money and primitive coins

700 - 600BC

Modern coinage Coinage takes modern orm in Lydia, westernTurkey

321 - 185 BC Bil ls o exchange Ear ly bi lls o exchange, promissory notes,Mauryan Empire, India

2nd - 3rdcentury AD

Annuities (widespread) Annuities common in Roman Empire

806-1023 Representat ive money Banknotes and paper money appear in China

14th century Bonds War as the ather o the bond market inRenaissance Italy

14th - 15thcentury

Reinsurance Early marine reinsurance

1602 Publicly listed stock Dutch East India Company on AmsterdamStock Exchange

1609 Standardized cur rency Issued by Amsterdam Exchange (Wisselbank)

1656 Fractional reservebanking (at money)

Innovation attributed to Swedish Riksbank

1688 Insurance brokerage Edward L loyd's London coee house, centre o rmarine insurance

18th century Options First call options on some Dutch stocks

1710 Futures Japanese rice utures market

1742 Monopoly on issuingbanknotes

Bank o England

1744 Insurance und Modern insurance industry with statistical basisbegins in Scotland

1773 Check clea ring house London bankers introduce clea ring house

1774 Mutual unds Early closed-end mutual und set up by Dutchmerchant

1829 Deposit insurance New York rst state to establish bank-obligationinsurance programme (circulating notes anddeposits)

1874 Standardized uturesexchange

Chicago introduces standardized uturescontract and clearing house

1880s Workers insurance andthe welare state Otto von Bismarck supports insurance andpensions or German workers

1913 Federal Reserve System Woodrow Wilson s igns US Federa l Reserve Act

1933 First national depositinsurance scheme

US creates Federal Deposit InsuranceCorporation in response to bank ailures

1938 Secondary mortgagemarket

Fannie Mae establishes secondary market orUS mortgages

1946 Venture capital Private equity rms established in United States

1949 Hedge unds Absolute return or hedged und created byAlred Winslow Jones

1950 Early credit card Diners Club International launches rstmulti-purpose charge card

1958 Modern credit card Bank o America launches credit card withrevolving credit line

Year Innovation Description

Table 2: Examples o Financial Innovation over the Centuries17

1950s Repurchaseagreements grow

Repo market expands rom late 1950s onwards

1960 Automated tellermachines (ATMs)

US patent led or early cash dispenser

1961 Reverse mortgage Former Maine bank CEOs idea helps seniorcitizens access housing equity

1968 Securitization (originateto distribute)

Ginnie Mae guarantees rst mortgagepass-through security

Late 1960s ATMs operational Cash dispensers deployed in London andelsewhere

1971 Floating exchange rates United States abandons xed exchange ratesystem

1971 Money market mutualunds

Bruce R. Bent and Henry B. R. Brown set uprst money market und in Uni ted States

1972 Debit cards City National Bank o Cleveland issues ATMaccount debit card

1970 - 1972 Foreign currency utures Development o FX utures in New York andChicago

1973 Black-Scho les model Nobe l p rize winn ing option-pricing model helpslaunch modern derivatives industry

1973 Point o sale term inals IBM launches POS term inals li nked tomainrame store computer

1974 Automated clearinghouses (ACH)

Electronic payments process replaces papercheques or routine payments

1974 IRA accounts United States introduces individual retirementarrangements

1975 Interest rate u tures In troduction o in terest rate utures in the Un itedStates

1976 Modern m icro-nance Muhammad Yunus beg ins research lead ing to

rst micro-nance bank in 19831978 401(k) 401(k) plan in the US encourages tax-riendly

retirement savings in stocks and bonds

1981 CHIPS (same daysettlement)

Clearing House Interbank Payments System asettlement wire transer system or the bankingindustry

1982 Consumer online stock trading

First ull-service consumer trading systemconnects traders around the world

1982 Stock index utures Kansas City Board o Trade introduces stock index utures

1987 Automated underwr iting Allnanz begins automation o li e insuranceindustry underwriting process

1988 International capitalrequirements or banks

Basel Accord (Basel I)

1989 Exchange traded unds First ETF launched in Canada

1992 Insurance-linkedsecurities

Lie insurers transer risk while releasing its valueto the open market through asset-backed notes

1992 Publicprivatepartnerships

UK government launches programme opublicprivate investment partnerships

1994 Credit deault swap JP Morgan structures one o the rst creditdeault swaps

1994 Value at Risk JP Morgan publishes VaR methodology

1996 Weather deri vatives Electr ic power company contract contains r stweather derivative deal

1999 Online payment ser vice PayPal launches online payments

2004 Usage-based insurance Pay-As-You-Drive car insurance

2004 Longevity bonds andswaps

First longevity bond announced



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Financial innovations have helped certain kinds o rms to cut thecost o unds raised or investment and to raise unds more securelyand quickly. For example, the venture capital industry, a nancialservices innovation, helped to launch many o the high technologyrms that created prosperity in the United States rom the 1950sthrough to today, including E-Bay/PayPal and Amazon. Innovationhas thus helped direct capital more eciently towards the right rms,and in doing so may have helped establish the United States as thehome o key technology companies. Finding new ways to identiy themost productive entrepreneurs and und their inventions might bealmost as important as the technical breakthroughs themselves.21

Many other innovations in the nancial system, such as incrementalimprovements to the worlds stock exchanges and clearing houses,have also made the fow o capital to business more ecient.

Other more recent and radical innovations that may help the world todirect its capital more eciently include the Internet marketplaces

that have sprung up to provide a new route to liquidity or investors instart-ups and other private companies (see the contribution byAlexander Ljungqvist in Part III on new innovative nancial servicesproviders).

Somewhat more controversially, the use o derivatives to manage

risk can be shown to oer business consumers a genuine benet inmany markets. Derivatives help to shit risk rom one party (e.g., amanuacturing corporation with exposure to a volatile oreigncurrency) to another (e.g. a bank that can lay o much o the risk inthe wider market and thereby diversiy that risk).

Certain kinds o derivative and complex nancial security wereactors in the recent crisis, as discussed in the next section. Butmany other derivative markets continue to allow participants tomanage risks that threaten and might destroy their businesses.

While it is easy to cite examples o how successul nancialinnovations have improved the world economy over the last ewdecades, and the choices available to consumers, it is harder toquantiy these benets. In particular, it is dicult to express innumerical terms the net benet o nancial innovations ater takingaccount o both positive and negative eects. However, it is worthhighlighting one recent qualitative study that concluded that, onbalance, there have been more benecial innovations than bad onesin recent years. Callout 6 provides more detail on Robert Litansassessment.

2.2.2 Benets since the Second World War

The last hal century or so has proved enormously productive interms o nancial innovation, powered by a number o

developments, most notably the twin engines o nancialliberalization and signicant advances in technology. Financialinnovation can be seen as a response to wider economic and socialorces and challenges. Since the 1970s, nancial liberalizationaround the world has created newly l iquid markets (e.g. currencymarkets) and the need or new nancial instruments to managethese market risks, while advances in computer technology haveincreased the speed o computation and enabled a host oinnovations, rom the network-enabled ATM to Internet banking.

The benets are perhaps most obvious to the general public in termso specic retail innovations. For example, debit cards oer both aneasy way to pay or goods and services, and obtain cash andaccount services, as well as a signicant benet in terms o personal

saety (compared to carrying large amounts o cash). Credit cards, inaddition, oer short-term nancing to consumers and a sae way tomake purchases by telephone and on line.

Innovations spawned by the Internet revolution itsel a wider GPTstyle innovation such as online banking oer the consumer hugeconvenience and, oten, better returns on savings and otherinvestment products. They have not caused major diculties to date,despite some continuing concerns about the stability o bankInternet systems and new opportunities to commit raud.

Benecial innovation in the nancial services sector extends wellbeyond innovative retail products. Some commentators18 believethat the main benets o nancial innovation lie in improvements to

the way in which nancial services ull their classical unctions in thebroader economy.

Table 3 lists some post-Second World War innovations against theclassication scheme oered in Tuano, 2003.

Functions Examples19

Innovation exists to complete inherentlyincomplete markets

Zero coupon bonds, derivatives, exchangetraded contracts

Innovation persists to address inherent

agency concerns and inormationasymmetries

Embedded options, direct selling, automated

underwriting, credit scores

Innovation exists so parties can minimizetransaction, search or marketing costs

ATMs, smart cards, ACH technologies,e-401(k) programmes, e-commerce

Innovation is a response to taxes andregulation

Zero coupon bonds, Eurodollar Eurobonds,mortgage-backed securities (MBS) andasset-backed securities (ABS), variousequity-linked structures used to monetizeasset holdings without triggering immediatecapital gains taxes, and trust preerredstructures

Increasing globalization and risk motivateinnovation

Foreign exchange utures, swaps and options;interest-rate utures, swaps, options, andorwards to manage increased volatility andnew risks arising rom globalization

Technological shocks stimulateinnovation

OpenIPO, olioFN

Table 3: Functions o Financial Innovation Dened by Tuano 200320

Quote 6: Alexander Ljungqvist, Ira Rennert Proessor o

Finance, NYU Stern School o Business

New private markets such as SecondMarket andSharesPost provide a welcome addition to the USnancial landscape and ll an important gap byenabling employees and investors to gain liquidityor their shares in private companies. ... Whatremains to be seen is whether the negative eectson the wider nancial market the externalities, inthe language o economists can be containedthrough thoughtul regulatory responses.




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Overall, the argument that nancial innovation has oered a net

benet to society is almost unassailable over the very long term, andit remains a strong argument or the period since the Second WorldWar.

The real challenge is how to increase the extent o this net benet byreducing the sometimes powerul negative outcomes associatedwith certain nancial innovations and their application in a givencontext. The clues or how to do this most eectively are likely toreside in the special nature o the nancial services sector and itsinnovations.

Callout 6: Assessing and Quantiying the Benets o Financial

Innovation

Assessing and quantiying the benets o nancial innovation is

widely recognized as being almost impossible due to the distinctcharacteristics o nancial innovation outlined in Chapter 2.3. Manyacademics, economic writers and other stakeholders agree on this,which is why the assessment o nancial innovation is usuallyqualitative. The web o externalities, as expressed by Lerner andTuano, makes it almost impossible to adequately quantiy the costsand benets o nancial innovation to arrive at the overall net impact.

This problem is cause or many rustrations that are expressedrepeatedly in public. For example, on 13 May 2010, an article titledFinancial Innovation, Known Unknowns appeared in the FreeExchange Economics blog o The Economist. It states:

[T]he extent to which discussion o the potential costs and

benets o nancial innovation tends to lack empirical estimations owhat, numerically speaking, those costs and benets might be andwhether the costs are bigger than the benets or the other wayaround eight years and a nancial market implosion later, werestill stunningly short o anything resembling conclusive evidence ...Perhaps the signicant and obvious costs o nancial innovation areentirely oset by dispersed and subtle benets. But while itsimportant to be open to this possibility, I dont think theres anyreason to simply assume that its true. ...

But why is it considered so important to know the exact impact onancial innovation? The assessment is most likely to infuenceregulation and policy o nancial innovation ultimately determiningthe extent to which nancial services can and will innovate going

orward. I the benets o nancial innovation are not acknowledged,clearly and in ull, allowing the nancial services sector to addresscontinuing social and economic challenges (see Chapter 6), we maylose out on many positive developments. The real question is howdo we keep the good parts o innovation without being stuck withthe bad, as nance proessor Raghuram Rajan says.

Source: Surowiecki, J. (2008) What microloans miss. The New Yorker, March 17. Available at: http://

www.newyorker.com/talk/nancial/2008/03/17/080317ta_talk_surowiecki

In the ollowing Table, a qualitative assessment o a ew selectednancial innovations appears. One o the most cited reerences orthis work is the paper In Deense o Much, But Not All, FinancialInnovation by Robert Litan, Vice-President or Research and Policyat the Ewing Marion Kauman Foundation in Kansas City (Litan,

2010). The ollowing assessment combines some o Litans ndingswith additional assessments or a wider range o products, such asinsurance.

While there are many examples o benecial nancial innovation and a ew are introduced in the text the ollowing table (largelybased on Litan, 2010) ocuses on some less common examples,highlighting the act that sometimes benets are subtle anddispersed, and so not obvious to everyone:

Innovation Examples Qualitative Assessment

Index Mutual Funds

(Collective investmentscheme replicatingmovements o an index)

This scheme provides access to capital markets at lower

cost with similar long-run returns as actively managedunds.

Less expensive delivery o portolio diversication thanactive management is indicative o a productivity gain.

This is balanced by reduced incentives or shareholdersto closely monitor individual companies.

Thus, there can be a downside i index unds account ora high proportion o all equi ties scale plays an importantrole in judging benet and risk.

Pay-as-you-go insurance

(Leveraging telematics tocapture data on theinsured partys behaviour e.g., auto insurance)

Data on a policy-holders behaviour can be used todetermine an accurate risk prole, translating intorisk-refective pricing.

This insurance increases transparency and airness, andalso encourages saer behaviours once thepolicy-holder refects that her behaviour directly impactsher premium.

Credit scoring

(Statistical assessment ocreditworthiness ocustomers using priorcredit tradeline paymentdata)

Credit scoring improved the pricing o risk or lenders,allowing lenders to extend credit to a wider group oconsumers and clearly increasing access to credit.

Eciency increased as well since credit scoring enabledmore cost-ecient underwriting processes.

Credit scoring is considered to have amplied morespending in good times with no eect in bad times whenconsumers tighten spending.

Reliance on low-cost, accurate credit scores may havemarginalized other traditional underwriting dimensions inthe pre-crisis credit markets.

Business interruptionpolicies or non-physicaldamage

(Covers non-physicaldamage through business

interruption)

This insurance allows the real economy to mitigate risksassociated with unexpected natural events that do notcause any physical damage but lead to the interruption obusiness activities, e.g., the damage that occurred to theaviation and airline industry during the volcanic ash cloudin spring/summer 2010.

It allows businesses to better predict and anticipate theimpact these risks could have on their business once theymaterialize and ensure that they do not lead to ail ure.

Micro-insurance

(Access to insurance orthe poor)

Studies have shown that, while the benets o insurancein developed markets are apparent to the consumer,there is little consumer acceptance across emergingmarkets.

By combining insurance products with micro-creditproducts, access to necessary insurance products, suchas lie and health insurance, is increased.

In less-developed markets, the impact o a healthemergency on the nancial situation o a amily can bedevastating but micro-insurance can provide a key hedgeagainst this damaging possibility.

Table 4: Examples o Financial Innovations and Their Benets



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Financial products are also big-ticket items, wrapped up in the mostimportant decisions in our lives. Few purchase decisions are biggerthan nancing a house and choosing a pension, or more potentiallyimportant than selecting lie or health insurance.

In addition, the nancial services industry is vulnerable to behaviouralbias, or the requent tendency or humans to make less than rationaldecisions (obviously not unique to nancial services). Thecontributions by Piyush Tantia and Margaret Miller in Part III o thisreport discuss this topic and take a look at how behavioural sciencemight help put guard rails around the process o innovation in theretail nancial sector.

Finally, leverage is a distinct eature o many nancial products (aswell as a eature o the nancial industry as a whole). It oten acts tomagniy the eect o negative outcomes. In May 2007, beore theevents o the nancial crisis unolded, Ben Bernanke (Chairman othe Federal Reserve) elaborated on leverage in relation to nancial

innovation:

The leverage that can be embedded in new nancial instrumentsand trading strategies compounds the diculties o riskmanagement. Embedded leverage can be dicult to measure; at thesame time, like conventional leverage, it may increase investorvulnerability to market shocks. Some credit derivatives do make iteasier or investors to take leveraged exposures to credit risk.24

2.3 Understanding the Particular Qualities o Financial

Innovation

2.3.1 Some General Observations

The nancial industry has distinctive characteristics,23 many o whichshape the nature and the eects o nancial innovation. In particular,the industry:

Plays a major role in allocating capital and thus enableseconomic growth and improved social welare

Is characterized by balance sheet leverage at levels that areunique compared to other industries

Is highly interconnected so that an innovation adopted by oneparty may negatively aect a third party with no directconnection to the innovation

The very reasons nancial rms can be so benecial to society their

links to the wider economy, leverage and interconnectedness magniy the economic and social eects o ailures in innovation riskmanagement. It is not only the individual institution that will eel theeect o its ailure but the wider economy through spillover eects.

Special Features o Financial Innovations

Many nancial innovations arrive with special eatures that determinethe size and shape o both positive and negative outcomes.

One is the long-term nature o many nancial services productscompared to, say, most manuactured products or services.(Although this eature is not unique to the nancial services industry:Innovations in other industries, such as asbestos and the

thalidomide drug, required a long time to show their negative sideeects.) It may take decades or a faw to become apparent in aninnovative pension or a long-term insurance product, not leastbecause the product is only asked to pay-out to work at theend o its contractual lie. While physical products such as cars andother durable goods can represent relatively long-term purchases,these purchases are usually put to use immediately, making it easierto spot major design deects.

Additionally, nancial products oten contain embedded eaturesthat trigger changes in outcome a relatively long time ater the sale othe product, e.g. the change in the interest rate or a mortgage roma xed to a foating rate.

In turn, the time it takes or outcomes to become apparent meansthat the innovative product may have been sold in large numbersbeore the error is ound. It may not even be considered aninnovation by the time its side eects begin to become apparent.Mortgages had been securitized or decades in standard ormatsbeore signicant negative side eects emerged during the nancialcrisis beginning in 2007.

The act that nancial products are oten paper or electronic ratherthan physical goods also tends to increase the volumes that canquickly be produced (and adopted) beore the product has beentested by time as well as making it easy to make urtherincremental innovations that may aect the nature o the outcome(e.g. by tweaking the characteristics o the original product).

The long-term nature o many nancial products and services iscompounded by the potential or asymmetries o inormationbetween the seller and the buyer. The designer o a new mortgageproduct is almost certain to understand the undamental risksassociated with the product better than most borrowers.

Quote 7: Piyush Tantia, Executive Director, ideas42

With the help o behavioural economics,perhaps nancial innovators will adopt saedesign practices as routine, just like engineersin other domains. Someday, we may even see anancial services ad showing o impressivecrash test results and saety eatures, just likecar manuacturers do today.




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Patterns o Innovation in the Financial Services Sector

On top o these special sector characteristics and product eatures,some commentators believe that certain patterns o innovation are

characteristic o the nancial services sector.

First, nancial innovations are usually highly dynamic, implying thatas a nancial innovation diuses rom early adopters to the massmarket, the structure o the product and the uses to which it is putchange over time as well as the costs, benets and externalitiesassociated with the innovation.25 It is likely, or instance, that the riskto consumers rom a new kind o washing machine, or even a newway o building bridges, will change little over time. However, the riskto the consumer and to society rom an innovation in derivativestechnology might be highly dynamic. An innovative component oderivatives contract might be benecial in one market and yetassociated with negative outcomes in another.

Second, nancial innovations can spawn a series o urtherincremental innovations. Merton (1992) introduced the term nancialinnovation spiral eect to describe this process. He pointed out thatthe development o a market in standardized products oten thenleads to more tailored, bilateral products. These tailored productsare then hedged on the standardized market, leading to yet morevolume, lower trading costs, and more encouragement to launchsimilar contracts and markets, spiralling toward the theoreticallylimiting case o zero marginal transaction costs and dynamicallycomplete markets.26

Third, the distinct pattern by which consumers adopt nancialproducts may itsel shape the likelihood o positive or negativeoutcomes. Many marketing experts (e.g. Rogers 1962)27 think about

product adoption in terms o a hierarchy that ranges rom earlyadopters (opinion leaders), through the majority o the population, tolate adopters. Early adopters tend to be better educated, morecondent and more willing to take time to learn about a product andexperiment, while later adopters tend to be less knowledgeable, lesswilling to learn and more conservative.

Clearly, this could lead to problems in the area o nancial innovation,particularly in the eld o credit and investments.28 For instance, itsuggests that the early adopters capable o understanding the riskso a nancial product will be ollowed by larger numbers oconsumers who are unwilling or unable to make the same kind ointellectual investment. Yet while a poor decision by the consumerabout a hair dryer has ew material consequences, a poor decision

about a big-ticket, long-term nancial product tends to be harder tobear. I large numbers o consumers are involved (e.g. in a mortgagemarket), there may be implications or the solvency o the provider,systemic risk and a serious eect on the real economy.

Quote 8: Margaret Miller, Senior Economist, Financial Inclusion

Global Practice, World Bank Group

Financial literacy and capability initiatives canhelp to mitigate potential negative outcomes orapid nancial innovation and should be part oa more comprehensive strategy or responsible

nance, which includes consumer protectionand working with providers to raise the bar on

product and service quality. Financial capabilityeorts may also be able to contribute to the

adoption o new products and services as wellas sustained positive behaviours, such as loanrepayment, committing to savings, etc. But tobe successul at these tasks, nancial literacy

and capability programmes themselves need tocontinue to innovate. This is happening as the

ocus is shiting rom simply providinginormation to consumers to understanding theactors that infuence their nancial behaviours

and then using new tools and technologies tosupport behaviour change.




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In the case o a radical innovation there is, by denition, no trackrecord to look back on. There may also be no easy way to becondent that it is appropriate to apply the available undamentaldata to estimate key variables. The ultimate consequence might bewrong estimates and biased expectations that lead institutions to setaside an inadequate amount o capital in the case o a retained risk or to communicate the wrong product risk prole to a consumer.

Finally, there may be no clear line between an incremental and aradical innovation. A relatively small change in the wording o anancial product, or a change to a marketing strategy, as mentionedearlier, can signicantly change outcomes; conversely, manyproducts are described as innovations in the marketplace when theyare really simply a dressing up o an established product. Thedierence between these two cases tends to be less obvious in thecase o an opaque nancial product than it might be in the case osome more tangible innovation such as, or example, a new orm ocar engine or a way to generate electricity

2.3.2 Knightian Uncertainty and the Dynamic Nature o theFinancial Services Innovation Environment

Characteristics o nancial innovations that tend to increase the

chance o negative outcomes were mentioned earlier, including thelong-term nature o many products and the tendency

Documents

WEF FS RethinkingFinancialInnovation Report 2012