What it means
Innovation in finance usually arrives in one of three forms. New products such as exchange-traded funds, new processes such as electronic settlement, and new institutions such as clearing houses or digital-only banks.
The motives are more mundane than the word suggests. Most financial innovation is driven by cutting transaction costs, sidestepping a regulatory or tax constraint, or repackaging risk so it can be sold to whoever is best placed to hold it.
Judging whether a given innovation is good for the economy rather than just profitable for its inventor is genuinely difficult. Index funds cut investor costs dramatically and are broadly agreed to be beneficial, whereas some pre-2008 mortgage structures were profitable to create and disastrous once the risk they concealed became visible.
For a business outside finance, the practical effect shows up in the cost and speed of ordinary operations. Instant settlement changes working capital needs, invoice financing platforms change how receivables are funded, and embedded payment tools change how customers pay at the point of sale.
The recurring nuance is that regulation follows innovation rather than anticipating it. New instruments often grow fastest in the gap between what the rules were written for and what the market has invented, which is where both the returns and the accidents tend to concentrate.
In practice
Real-world examples.
Example
A fund manager launches a low-cost index tracker charging 0.07% a year against 0.85% for its actively managed equivalent. On a $50,000 investment that is $35 a year rather than $425, and the flow of money towards trackers forces the whole firm to reprice its range.
Example
A logistics company starts selling insurance cover at the point where a customer books a shipment, rather than referring them to a broker. Embedding the product raises attachment rates from 6% to 23% and creates a new commission line worth $1,400,000 a year.
Example
A regional lender adopts open banking data to underwrite small business loans from live bank feeds instead of two-year-old accounts. Decision time falls from eleven days to under an hour, and default rates stay flat because the data is more current than the accounts it replaced.
Formula
Calculation
Annual saving = (old unit cost - new unit cost) x annual volume. Simple payback period = implementation cost / annual saving.
A mid-sized bank processes 40,000,000 payments a year on legacy infrastructure at a cost of $0.45 each, giving an annual cost of 40,000,000 x $0.45 = $18,000,000. A new real-time payment rail would cut the cost to $0.12 per payment, or 40,000,000 x $0.12 = $4,800,000 a year.
The annual saving is $18,000,000 - $4,800,000 = $13,200,000. Building and migrating to the new rail costs $30,000,000, so the simple payback period is $30,000,000 / $13,200,000 = 2.27 years, a little over 27 months. Over a five-year horizon the innovation returns 5 x $13,200,000 = $66,000,000 of savings against $30,000,000 of cost, a net gain of $36,000,000 before any revenue from new services the rail makes possible.Case study
Seen in the real world.
The following is an illustrative and fictional case. Beckworth Trade Finance, an invented specialist lender, watched its core business of financing export invoices shrink as banks automated the same product. Rather than compete on price it built a platform that split each invoice into small participations and sold them to institutional investors within 24 hours of approval.
The illustrative innovation changed the economics. Previously Beckworth funded $200,000,000 of invoices a year using its own $50,000,000 balance sheet and earned a 4% net return on that capital, or $50,000,000 x 0.04 = $2,000,000 a year. On the new model it originated $600,000,000, kept 10% on its own books and earned a 1.5% origination and servicing fee on the whole volume, giving $600,000,000 x 0.015 = $9,000,000 plus margin on the retained slice.
The fictional company also discovered the standard hazard of financial innovation. When one large exporter failed, investors argued that Beckworth had underwritten the credit rather than merely distributed it, and the firm ended up absorbing $4,300,000 of losses it believed it had passed on. Documentation, not technology, turned out to be the part that needed the most careful work.
Watch out
Common mistakes.
- Assuming that because an instrument is new and complicated it must be more sophisticated, when complexity often just hides where the risk has been moved.
- Judging an innovation only by its cost saving, ignoring whether it creates concentration, opacity or a new dependency on a single provider.
- Believing regulation will catch problems early, when rules are usually written after an instrument has already grown large.
Questions
People also ask.
Is all financial innovation risky?
No, plenty of it is dull and beneficial, such as electronic settlement, index funds and instant payments, which mostly reduce cost and operational risk.
What drives most financial innovation?
Cutting transaction and information costs, responding to tax or regulatory constraints, and repackaging risk so it can be sold to parties better able to carry it.
How should a non-financial business evaluate a new financial product?
Ask what it costs in total, what happens in a stressed scenario, who bears the loss in that scenario, and whether the answer is written clearly in the contract.
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