Financial Innovation

1. Financial Innovation Shahid Yusuf DRG World Bank September 22, 2006

2. Financial Innovation: Impact and Trend • Potential contribution of financial innovation to allocative efficiency and growth is rising rapidly. • Scope for innovation magnified by advances in information and communications technology and by computerization. • Financial liberalization and global market integration also promote innovation by increasing competitive pressures and widening opportunities.

3. How Innovation Promotes Economic Activitiy • Convenient and higher yielding instruments for savers, greater access to credit for borrowers, e.g. derivatives for tailoring contracts, credit scoring, securitization. • Assists in the collection and analysis of information. • Facilitates monitoring of funds by lenders. • Transfers riskiness of assets by pooling and repackaging.

4. ICT Has Boosted Innovation • IT has increased the volume of information collected. • Digital technology and computerization permits rapid, detailed analysis. • New advances in modeling, algorithms, and software have provided tools such as capital asset pricing, pricing of options, better risk assessment, and made these tools easy to use. • Structuring and customization of financial products now possible to serve numerous market niches. • Together with relaxing of regulations, ICT has led to global integration of financial markets.

5. ICT/Globalization Affecting Policy, Organization, and Institutions • Global financial flows requiring more effective monitoring, policy coordination, and quicker speed of response by: • Inducing delayering of organization and unbundling of activities, e.g. back office and analytic modeling, etc., and outsourcing to specialized suppliers. • Emphasis on measures for greater transparency, improved auditing practices, better governance, stronger legal rules to support financial innovation, and regulatory reforms to contain risk of fraud and instability.

6. Gains from Financial Innovation • Greater allocative efficiency raising factor productivity. • Facilitating “creative destruction” through entry and exit of firms. • Transaction costs reduced by ATM machines, smart cards, and ACH transfers. • Use of IT permitted CMAs, MMAs, sweep accounts, VAR analysis, stress testing of portfolios, open IPOs (without underwriting), etc. • Credit scoring and internet websites make possible geographical expansion and long distance transactions.

7. Who Innovates, Where Does Innovation Occur? • In the U.S., smaller, less profitable financial firms often take the lead. • Big banks with branch networks have been quicker to exploit innovation with scale economies, e.g. credit scoring, ATM, internet services, new types of securities. • Most innovation takes place in a few financial centers with clusters of firms supported by other business services.

8. The Future of Innovation is Bright Because: • Potential of IT and digital technologies still to be exploited. • Finance attracting a lot of creative talent. • Improving intellectual property rights will help. • Aging of population spurring new innovations such as reverse mortgages, annuities, and survivor and mortality bonds.

9. China’s Financial Status, Constraints, and Future Directions • Large and rapidly growing financial sector, but financial systems is bank-centered and lends mainly to the state sector. • Bond, mortgage and consumer credit markets underdeveloped. • Risk management practices, outsourcing by banks inadequate. • Stock market hampered by small percentage of tradable shares, equity pricing, and corporate governance. • Global integration and competition limited. • Financial innovation will need to be paralleled by strengthening of legal and regulatory institutions, and implementation capacity.

10. Concluding Observations • Possibilities for financial innovation in China are large. • Financial sector can be an engine of growth, and can support productivity gains throughout the economy.