How to Promote Innovation in Financial Services?

How to promote innovation in financial services industry? Presentation at the Valiko’s 25-years jubileum 4.10.2012

Professor Olli-Pekka Ruuskanen Insurance Science School of Management University of Tampere

Content

1.  Introduction 2.  Innovation in financial services 3.  New challenges 4.  Regulation and innovation 5.  Conclusion

Olli-Pekka Ruuskanen

Situation today

•  Customers demand more choices, increased transparency in rates and greater convenience.

•  Governments demand more transparency and more adherence to risks

•  Competitors are emerging with new business models and non-traditional delivery methods

(Peverelli and De Feniks 2010)


Future trends

•  Demographics •  Big data and telematics •  Social computing •  Mobile web •  Scalability in cloud •  Polarization: Cheapest versus convenience •  Regulation •  Globalization


89% of insurance CEOs indicate that their organization will need to implement

substantial change.

IBM Global CEO Survey, 2010


Functions delivered by financial systems

1.  Moving funds across time and space 2.  Pooling of funds 3.  Managing risk 4.  Extracting information 5.  Addressing moral hazard and asymmetric

information 6.  Facilitating sale through payment system.

Merton (1992)


”Finance is technology”, Robert Schiller


Definition

•  ”Financial innovation is the act of creating and popularizing new financial instruments, technologies, institutions and markets.”

Peter Tufano, Harvard Business School


What innovation does in finance (1) 1.  Innovations exist to complete incomplete

markets 2.  Innovation persists to address inherent agency

concerns and information asymmetries 3.  Innovation exists so parties can minimize

transaction, search or marketing costs


What innovation does in finance (2) 4.  Innovation is a response to taxes and

regulation 5.  Increasing globalization and risk motivate

innovation 6.  Technological shocks stimulate innovation


INNOVATION = IDEA + COMMERCIALIZATION


” In the past 25 years the only useful

innovation in finance has been ATM.”

Paul Volcker, Former Chairman of Federal Reserve, 2009


What makes innovation difficult in finance? •  Conservativism •  Protecting intellectual property difficult •  Finland is a small market, can’t recoup

investments •  Risk avoidance •  Regulation hinders innovation •  The shadow of the 2007/2008 financial crises


What makes innovation difficult in finance? (… continued) •  Maturity of the market •  Limits to insurability •  Lack of demand / financial literacy •  Data limitations •  Ambiguity of risks •  Asymmetric information •  Basis risk


We can not differenAate our product!

Evidence from national surveys on innovation •  Importance – How many firms active

•  Intensity – Expenditure on R & D

•  Ingenuity – New to firm / new to market


Case: Insurance and Financial Services •  Variation in reported innovation activities across

countries •  Innovation in financial intermeditation large •  80 % German insurers claim innovative products •  The share of turnover from new products lower

in financial services •  Skewed towards smaller countries


How difficult to copy innovations?


Innovation in financial services industry

Types and Degrees of Innovation Product Process Organisa0onal Service

Incremental

EvoluAonary

DisrupAve/Radical



Examples of innovation in banking and insurance


Examples

•  Mutual funds •  Exchange traded funds •  Catastrophy/mortality bonds •  Alternative Risk Transfer •  Algorithmic trading •  Insurance futures •  Industry loss warranties


Major innovations in insurance


Finance is a Service

•  Banking •  Insurance •  Knowledge engineering


Service industries are about solving consumer problems •  What fundamental problem is the customer

trying to solve? •  What objectives do customers use to evaluate

solutions? •  What barriers limit the solution? •  What solutions do customers consider? •  What opportunities exist for innovative solutions?


Incremental innovation in insurance

•  Policy amandments •  Bundling and unbundling •  Parametric insurance


Mutation in innovation

•  Innovation often intentionally span across different labels.

•  Financial innovation spiral (Person & Warther 1997) •  ”Adoption provides other participants with information

about the profitability of innovation, creating waves of innovation and S-curve”

•  Security created -> slightly modified by competitors •  1980 – 2001 1,836 security codes in Thomson-

Reuters database.


In finance counterparty matters

•  B 2 C

•  B 2 B

•  B 2 W

•  I 2 R


Back office problems

•  Infrastructure lacks when innovation takes off •  Trade confirmation •  Settlements •  Contractual verification and standardization •  Risk aggregation •  Collateral determination


New challenges

Motivation for innovation?

”There are things we know, that we know. There are things we know, that we don’t know. and then there are those things that we don’t know that we don’t know.”

Colin Powell, 1991


Unstructured versus structured data

•  Banking and insurance have used structured data

•  The challenge of unstructured data •  Legacy systems •  Real time underwriting •  Real time credit •  Semantic web


Real time, ubiqious, personal data

•  RFID technologies •  GPS •  GIS •  Digital imagery •  Health informatics •  Genetics

•  Privacy?


Patents in Financial Services

•  Business method patents •  State Street v Signature Financial, 1998. •  U.S. Patent Office •  2010 reduction in scope ”Bilski vs Kappos”-

ruling •  Failure of finance patents to give proper

attribution to prior art •  Few patent litigation cases in U.S. finance •  European Patent Authority


Microfinance and microinsurance

•  Microfinance is typically a small loan given to low-income people without collateral guaranteed by a group.

•  Microinsurance is protection of low-income people against specific perils in exchange for regular premium payments proportionate to the likelihood and cost of the risk involved.

•  Cost efficency is key.


My personal favorites

•  Proactive transparency •  User assigned reputation scores •  Consumer based buying clubs •  User based underwriting and risk assessment •  Telematics •  Claims tracking systems •  Mass customization •  Supporting data disclosure or low-risk

demonstration


Regulation and innovation

Regulation

”Finance is at its most dangerous when it is perceived to be safe.”

Andrew Palmer, The Economist


Frameworks for innovation

•  Basel III

•  Solvency II

Is there room for innovation?


Regulation and Innovation (1) (Lumpkin 2008)

1.  Adopt an unbiased stance. 2.  Ensure that necessary framework conditions for

markets to function 3.  Acknowledge that there is no one policy

measure that can be considered optimal in all circumstances



4.  Ensure that the policy instruments needed to achive incentive-compatible objectives are in the toolkit.

•  Clarify what is meant by maintaining systemic stability

•  Properly address exit problems for large institutions

•  Establish a proper macro-prudential framework •  Establish a proper consumer protection

framework



5.  Ensure regulators and supervisors have the requisite skills and expertise

6.  Ensure a proper balance between regulation and governance

7.  There should be appropriate monitoring of a new products, markets and processes

8.  Adopt the regulatory system as a necessary to the market environment it is intended to regulate


Tipping point

•  Finance lacks ”off” button •  When does a new innovation become

systemically significant? •  When will the flaws in innovation start having far

reaching consequences?


Regulatory evaluation of financial innovations •  Target of innovation •  Core purpose of innovation •  True value added or transfer between

participants •  Key assumptions underlying innovation •  Timing of innovation •  Revolutionary or adaptive •  Change in institutional structure or business

models.


”Some radical innovation may ultimately be needed to deliver sustainably higher growth”

Darren Pain, Swiss Re


Conclusions

•  Financial services industry needs more innovation and creativity in the future.

•  Technology and data are keys to disruptive innovation.

•  Paradigm shift: from conservative to innovative culture within organizations.

•  Regulation is a constraint. Should be possibility


Thank you e-mail: [email protected] http://fi.linkedin.com/in/ollipekkaruuskanen twitter: @opruuskanen

Economy & Finance

How to Promote Innovation in Financial Services?