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 Financial innovation: Background

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عدد الرسائل : 2061
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Localisation : المملكة العربية السعودية
تاريخ التسجيل : 11/05/2007

مُساهمةموضوع: Financial innovation: Background   الأحد 20 يناير - 20:19

W. Scott Frame, Lawrence J. White, “Empirical Studies of Financial Innovation: Lots of Talk, Little Action?”, conference on “Innovation in Financial Services and Payments”
Federal Reserve Bank of Philadelphia, May 16-17, 2002, pp2-13.


II. Some Background
Although financial innovation is all around us – the plastic in our wallets, the new financial instruments listed in the daily financial pages, the now-ubiquitous automatic teller machines (ATMs) that likely dispensed most of the cash that we carry in our purses and pockets - a background discussion of financial innovation will be worthwhile.
A. What is financial innovation?
"The primary function of the financial system is to facilitate the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment." (Merton 1992, p. 12) This function, in turn, encompasses a payments system with a medium of exchange; the transfer of resources from savers to investor-users of the resources (and the eventual repayment to the savers); the gathering of savings for the purposes of pure time transformation
(i.e., deferral/smoothing of consumption); and the reduction of risk through insurance and diversification.
The operation of a financial system involves real resource costs, such as labor, materials, and capital employed by financial intermediaries (e.g., banks, insurance companies, etc.) and by financial facilitators (e.g., stock brokers, market makers, financial advisors, etc.). Further, since multiple time periods are an inherent characteristic of finance, there are also uncertainties about future states of the world that generate risks. For risk-averse individuals, these risks represent costs. The possibility of new financial products/services/instruments that can better satisfy financial system participants' demands is always present. Viewed in this context, a financial innovation represents something new that reduces costs, reduces risks, or provides an improved product/service/instrument that better satisfies participants' demands.
Financial innovations can be grouped as new products (e.g., adjustable rate mortgages; exchange-traded index funds); new services (e.g., on-line securities trading; Internet banking); new "production" processes (e.g., electronic record-keeping for securities; credit scoring); or new organizational forms (e.g., a new type of electronic exchange for trading securities; Internet-only banks). Of course, if a new intermediate product or service is created that is used by financial services firms, then it may become part of a new financial production process.
There are close analogies with familiar forms of innovation in non-financial contexts.
There we see new products (e.g., DVD players; self-stick postage stamps); new services (e.g.,
Internet-based retail shopping); new production processes (e.g., improved processes for manufacturing computer chips) and new organizational forms (e.g., the "M-form" decentralized corporate structure). And innovations in producer goods are often essential for innovations in production processes.
Much of the research attention to innovation focuses on the new idea. But at least as important is the adoption and spread of an innovation -- its diffusion -- across an industry. Faster diffusion means a higher societal return on the underlying investments in the innovation.
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مُساهمةموضوع: رد: Financial innovation: Background   الأحد 20 يناير - 20:19


B. Why is financial innovation important?
Innovation is clearly an important phenomenon in any sector of a modern economy.
Although standard microeconomic theory (rightly) focuses much of its attention on the issues of static resource allocation and economic efficiency, there is nevertheless general appreciation that performance over time is driven by a variety of dynamic factors, including innovation. The centrality of finance in an economy and its importance for economic growth (King and Levine 1993a, 1993b; Levine 1996, 1997, 1998, 1999; Levine and Zervos 1998; La Porta et al., 1997,
1998; Rajan and Zingales 1998) naturally raises the importance of financial innovation.
Since finance is an input for virtually all production activity and much consumption activity, improvements in the financial sector will have positive direct ramifications throughout the economy. Further, since better finance can encourage more saving and investment and can also encourage better (more productive) investment decisions, these indirect positive effects from financial innovation are yet greater still.
III. What Motivates Innovation in General and Financial Innovation in Particular?
Profit-seeking enterprises and individuals are constantly seeking new and improved products, processes, and organizational structures that will reduce their costs of production, better satisfy customer demands, and yield greater profits. Sometimes this search occurs through formal research and development programs; sometimes it occurs through more informal "tinkering" or trial and error efforts. When successful, the result is an innovation.
If the search-and-success were a relatively constant phenomenon, innovations would tend to appear in a roughly continuous stream.
Since the observed streams of innovations do not appear to be uniform across all enterprises or across all industries, the general innovation literature (see Cohen and Levin 1989) has sought to uncover the environmental conditions that may encourage greater (or lesser) search efforts and a larger (or smaller) stream of innovations. That literature has focused on hypotheses concerning roughly five structural conditions:
(1) The market power of enterprises;
(2) The size of enterprises;
(3) Technological opportunity;
(4) appropriability; and
(5) Product market demand conditions.
We will first briefly sketch these general conditions and then will focus on financial innovation and the environmental factors that the descriptive literature (cited above) suggests may encourage financial innovation; we will also relate these latter factors back to the general conditions.
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تاريخ التسجيل : 11/05/2007

مُساهمةموضوع: رد: Financial innovation: Background   الأحد 20 يناير - 20:20


A. General structural conditions.
1. Market power.
This hypothesis originates with Schumpeter (1950), who argued that market power is necessary to permit firms to generate sufficient returns from innovation. This is because of:
(1) The inherent public good/free rider problems associated with new ideas, and
(2) The difficulties of obtaining the finance for the sizable and uncertain investment in research and development (R&D) that is required for successful innovation.
2. Enterprise size.
This hypothesis also is identified with Schumpeter (1950). A larger size of an enterprise implies that the sale of the product embodying the innovation is likely to be large, yielding a greater return on the investment in the innovation. Also, greater size is necessary to allow the firm to accommodate the economies of scale inherent in R&D facilities, which are necessary to yield innovations. Finally, greater size is more likely to accommodate a wider range of activities and products, which may allow the firm to capture more of the unexpected spin-offs of the uncertain R&D process.8
3. Technological opportunity.
Some industry technologies seem inherently more susceptible to innovation. For the past few decades, for example, computer chips, hardware, and software have experienced rapid technological progress. In earlier decades, the chemical industry seemed to have this susceptibility.
4. Appropriability.
As mentioned above, information has the properties of a public good. In the absence of some protection or frictions, a productive new idea will be rapidly copied by rivals (who, in a competitive marketplace, will price their output at marginal cost), thereby depriving the originator a return on his original investment in the innovation. The property rights regimes embodied in patents, copyrights, and trademarks provide some protections for innovators.
Trade secrets and proprietary know-how provide additional protections, even where formal intellectual property protections are not available.
5. Product market demand conditions.
Market size and growth are the main features capturing product market demand conditions. Specifically, a larger market will provide a greater return to a successful innovative effort; while a growing market is likely to provide the rents (profits) that can both entice and finance innovation. Other market characteristics might also be influential, such as the variability of demand, general macroeconomic conditions, tax regimes, regulatory regimes, etc.
It should be emphasized that these conditions are hypotheses, to which counter-hypotheses have sometimes been offered. For example, in contrast to the Schumpeterian hypotheses that suggest that monopoly and giant size are conducive to rapid innovation, Scherer (1984) suggests that smaller firms, with (at most) only modest levels of market power, may be more likely to be rapid innovators, because of the competitive pressures that are absent in the "quiet life" world of monopoly.
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عدد الرسائل : 2061
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تاريخ التسجيل : 11/05/2007

مُساهمةموضوع: رد: Financial innovation: Background   الأحد 20 يناير - 20:20


B. The conditions that influence "equilibrium" rates of financial innovation.
The descriptive literature that we cited above has suggested a number of environmental factors that have encouraged financial innovation. The list provided by Campbell (1988, ch. 16) is the most inclusive, and we will draw heavily on it. But, as good as Campbell's list is, it is seriously incomplete, because it focuses only on the levels of environmental factors and neglects changes in environmental factors, as we will explain below.
1. Underlying technologies.
The basic underlying "physical" technologies of finance are those of telecommunications and data processing, which permit the gathering of information, its transmission, and its analysis. Increasingly, these technologies allow financial market participants to measure and manage their risk exposures more efficiently and effectively. For example, with respect to lending, asymmetric information problems imply that lenders have difficulties determining who is a creditworthy borrower (adverse selection) and also have difficulties monitoring borrowers after a loan has been made (moral hazard). Accordingly, better (more advanced, faster, lower cost) physical technologies have permitted more innovations (e.g., credit and behavioral scoring) that allow lenders better to overcome those asymmetric information problems. Similarly, in terms of market risk, the use of value-at-risk and portfolio stress testing provide useful risk measures that can be used internally to set risk tolerance levels or allocate capital and externally to provide investors with a sense of overall exposure. Better physical technologies may also permit organizational innovations (e.g., electronic securities exchanges) that would not be possible with less advanced technologies.
There is another technological dimension that is important for finance: intellectual technologies, such as the Black-Scholes option pricing model or the capital-asset-pricing model (CAPM). Advances in these technologies will, again, permit a wider range of innovations (e.g., computer programs that will readily compute option values).
This category of environmental conditions for financial innovation has a direct parallel to the "technological opportunity" category of the general list above.
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تاريخ التسجيل : 11/05/2007

مُساهمةموضوع: رد: Financial innovation: Background   الأحد 20 يناير - 20:21


2. Macroeconomic conditions.
Unstable macroeconomic conditions -- e.g., fluctuating prices, interest rates, exchange rates -- create uncertainties and risks and thus are likely to spur more innovation (to alleviate those risks) than would be true in a stable macroeconomic environment. Greater instability is likely to be associated with a faster pace of innovation.
This environmental condition seems best categorized as a parallel of "product market demand conditions" in the general list.
3. Regulation (legal environment).
Regulation is a two-edged sword. On the one hand, some forms of regulation must inhibit innovation. For example, if regulation prevents commercial banks from owning insurance companies (and vice-versa), then whatever innovations might arise from joint ownership and operation will not occur. But, on the other hand, it is also clear that innovation can arise from efforts to circumvent regulation. To continue with the bank/insurance example, if cross-ownership is prevented, then banks will have the incentive to create insurance-like products and services (but, of course, will avoid labeling them as insurance), while insurance companies will have an incentive to create bank-like products. Accordingly, it is impossible a priori to assign a positive or negative sign to the connection between the stringency of regulation (however measured) and the pace of financial innovation Also, the innovation that arises as a consequence of regulation may be a socially positive or negative phenomenon.
This depends on whether one sees the regulation itself as socially worthwhile (so that innovative evasion is a waste of resources or may even have socially deleterious consequences) or as a social waste (in which case the innovative evasion is a second-best improvement).
Again, this environmental condition seems best categorized as a parallel of “product market demand conditions” in the general list.
4. Taxes.
To the extent that a tax system levies differential taxes on different streams of income or on different categories of assets, the higher taxed parties will seek ways of reducing their taxes. Financial innovation will follow. Higher levels of taxation will likely yield a larger flow of innovation. Again, whether one sees this innovation as a socially positive or negative phenomenon will depend on the social interpretation that one puts on the differential taxation scheme.
Again, this environmental condition seems best categorized as a parallel to "product market demand conditions" in the general list.
5. Other influences
It is noteworthy that Campbell’s list does not include appropriability (and the intellectual property considerations that are associated with appropriability) or the Schumpeterian hypotheses of firm size and market power. Traditionally, the intellectual property protection system (i.e., patent, copyright, trademark) has not been considered important for financial innovation; patents for financial innovations were a rare phenomenon before 1980 and only became noticeable and significant in the 1990s (Lerner 2002). Since Tufano (1989) shows that imitation of some innovations is rapid, a regime of intellectual property protection could encourage greater innovation. As for the Schumpeterian hypotheses, the absence of formal R&D facilities in financial services firms has probably been a significant factor in the relative neglect of the size and market-power considerations with respect to financial innovation.
Also, neither the general innovation literature nor the financial innovation literature has addressed in a substantial way networks and network externality effects (Rohlfs 1974; Economides and White 1994; Katz and Shapiro 1994; Besen and Farrell 1994; Liebowitz and Margolis 1994) and their potential effects on the type and pace of innovation. With network effects, the benefits to incumbent members of a network increase as more members join the network. Also, economies of scale and compatibility among members are usually important features of networks.

The implications for innovation are cloudy, but potentially important. Incremental innovations within the compatibility confines of a network are clearly possible. But the scale-related problems of creating new networks may discourage such “large” innovations.
6. Interactive effects.
The categories discussed above are not mutually exclusive. There may well be interaction effects among them. For example, regulations that are non-binding under one set of environmental conditions may be binding under another and may inspire circumventing innovations in the latter state, provided that the technological capabilities are present. It is clear that the greater macroeconomic fluctuations of the late 1960s and the 1970s caused a tighter binding of the Federal Reserve's Regulation Q (which limited the payment of interest on deposits). This, in turn, inspired innovations such as money market mutual funds and "sweep accounts" for bank deposits; but the latter would not have been possible without the improved computer and telecommunications capabilities of the 1970s.
C. Changes in environmental conditions.
The environmental factors described above represent the influences on the "equilibrium" flow of financial innovation. What are left out of that discussion is the consequences of a change in an environmental condition. When changes occur, we expect an initial wave or flurry of financial innovations that represent an initial response; the flow of innovations will then, over time, settle to a new equilibrium flow that is appropriate to the new environmental conditions.
Thus a significant change in any of the major environmental categories would likely induce (with some lag) its own initial wave of innovations that would eventually settle to a lower equilibrium rate.
For example, the end of fixed exchange rates and the greater uncertainty surrounding fluctuating exchange rates in the early 1970s would naturally have led to an initial flurry of financial innovations -- foreign exchange forward contracts, futures, and options -- to respond to the change and that might have been feasible before the change but simply was not demanded.
After this initial wave (which could be of indeterminate length, because of lags), financial innovation in this area would settle to a new equilibrium flow (which would likely be greater than the old equilibrium flow, because of the changed environment). And if the system of exchange rates were perceived to shift to a new "regime" of even greater variability, then we would expect to see another flurry of innovation.
Accordingly, it appears that the wave of innovations of the 1970s and 1980s that inspired the descriptive literature that we cited above15 was in part a response to changes in important environmental factors at the time, such as the rise in levels and variance of interest rates; the end of the Bretton Woods regime of fixed exchange rates; rapid technological changes in telecommunications and data processing; and major intellectual breakthroughs, such as the Black-
Scholes model. This perception of a wave due to changes in the environment would be consistent with Miller's (1986, p. 471) prediction that "the prospect for the future is for a slowing down of the rate of financial innovation ... a slowing down of innovation, not an end to further progress."
Further, in this context of environmental changes, even if a regulation or a tax rate changes in a direction that creates an environment that would induce a reduced equilibrium flow of evasion-motivated innovations, there might nevertheless be an initial wave of greater innovation as the participants in the financial markets adjust to the new environment.
Finally, these dynamic considerations are probably best categorized as a parallel to the "product market demand conditions" of the general list.

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Financial innovation: Background
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