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Journal of Innovation Management Arthur
JIM 5, 4 (2017) 48-73
HANDLE: http://hdl.handle.net/10216/110854
SM: Jan/2017 AM: Nov/2017
ISSN 2183-0606
http://www.open-jim.org
http://creativecommons.org/licenses/by/3.0 48
The emergence of financial innovation and its governance
- a historical literature review
Keren Naa Abeka Arthur
Centre for Entrepreneurship and Small Enterprise Development, School of Business, University
of Cape Coast, Cape Coast, Ghana
keren.arthur@ucc.edu.gh
Abstract.
This paper reviews the literature from diverse disciplines in order to
trace historically, the emergence of financial innovation and its governance. It
starts with a charting of the occurrence of financial innovations throughout
history, followed by a chronological mapping of the introduction of
mechanisms to govern these innovations. It then discusses findings from the
review in order to shed light on the extent to which financial innovation
governance approaches used throughout history were sufficiently robust to
ensure the emergence of responsible financial innovation. Findings show
changing drivers of financial innovation across history with no evidence of
specific governance mechanisms for the process of financial innovation itself.
What exists are mechanisms for governance of the financial sector, in the form
of legal frameworks, policies and self-regulatory mechanisms that place
emphasis on regulation of the products of financial innovation after these have
been developed and implemented. The paper is concluded with a brief
discussion on implications for theory.
Keywords:
Financial innovation, Innovation governance, Regulation, Self-
regulation, Responsible innovation.
1 Introduction
Following the financial crisis of 2007/2008 the assumption that innovation
contributes positively to finance and welfare has been challenged (Sánchez, 2010;
Corsi, et al., 2016; Fostel & Geanakoplos, 2016), and the balance of risks and benefits
of financial innovation to society questioned (James, 2015; Beck et al., 2016).
Financial innovation has received various criticisms from the media, the public,
policy makers and top economists in society (Litan, 2010). Thus actors (e.g.
Armstrong et al., 2012, Asante et al., 2014) have become interested in finding ways to
preserve the benefits of financial innovation, while at the same time limiting the
impacts and risks of financial innovations that have the potential to be harmful. This
begs the question of how financial innovation occurs, how it is governed, and how
adequate current mechanisms, including regulation, for governing financial
innovations are in predicting and managing their wider impacts before they occur;
questions that this study hopes to address. Answers to these questions could shed light
on the context within which innovators in the financial sector must understand and
frame any conceptualisation of responsible financial innovation.
Allen and Gale (1997), Goetzmann and Rouwenhorst (2005) and Allen and Yago
(2010) argue in favor of a studying financial innovation from a historical perspective
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JIM 5, 4 (2017) 48-73
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when they discuss at length major financial innovations that have occured in history
in their research publications. While these are useful, they do not consider how these
innovations have been governed through history. Such an activity allows for
comparison between when specific financial innovations occurred and when
mechanisms were introduced to govern them. Further, comparisons of this nature can
be considered useful because according to Hu (2015), some theories associated with
financial innovation, for example decoupling, can have implications for information-
based governance mechanisms. Therefore, this paper seeks to take the works of Allen
and Gale (1997), Goetzmann and Rouwenhorst (2005) and Allen and Yago (2010) a
step further. I describe the emergence of financial innovation and its governance.
Specifically, the paper charts the emergence of financial innovations and associated
governance throughout history and compares the two in order to assess whether
innovation management and governance approaches used throughout history have
been sufficiently robust to ensure the responsible emergence of financial innovation.
Further the paper highlights lessons that can be learnt from the review with regard to
the motivation, drivers and types of financial innovation.
2 Research Methodology
A review of the literature (Bhatt and Bhatt, 1994; Brundage, 2013; Salevouris and
Furay, 2015; Marius and Page, 2015) suggests three activities are crucial in the
historical review process; collecting data, verifying its authenticity and organising,
analysing and writing it out. Regarding data collection, these authors highlight
primary and secondary data as the main sources which historical researchers can use;
and acknowledge that access to primary data could be limited, in which case use of
secondary data sources only is justified. To this end, the study uses mainly data from
secondary sources.
The main approach of this study is to juxtapose a review of the literature on the
emergence of major financial innovations in history and their governance. To identify
the articles to be used for the study, research was conducted from secondary sources
of data including journal articles, books, encyclopedias and newspapers. The search
for relevant material started in bibliographic databases (JSTOR, Emerald and
EBSCO) using key words such as “financial innovation”, “innovation in financial
services” “history of financial innovation” and “governance of financial innovation”.
This yielded a large number of articles which allowed for the identification of
innovations considered significant in the financial services industry, but with limited
details about the event. Further, the search on governance of financial innovation
returned fewer relevant articles. Therefore, for each major innovation identified, a
more targeted search was conducted in the bibliographic databases stated above, and
in a few cases on the Web to find relevant material that shed light on when, where,
why and by whom the first form of the financial innovation emerged, what type of
governance mechanism existed to govern the innovation, when and why that
mechanism was introduced.
Salevouris and Furay (2015) argue that there is no hard and fast rule in selecting
literature to be used for historical writings. However, he suggests a number of things
that could be useful to consider including how up-to-date the literature is, whether the
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source references of the literature is substantive and whether the work is respected by
other researchers in the field. These guidelines as well as others such as relevance to
topic, acceptance by fellow researchers and influential strength (i.e. the extent to
which the author of selected literature has influence on the advancement of
knowledge in the field of study) suggested by Karayiannis (1998) were employed in
choosing literature used for the study. Where possible, scholarly secondary sources
were used; and for relevant events identified, multiple data sources were reviewed to
ensure authenticity and reliability of information.
The study used both the narrative and analytical modes of historical writing suggested
by Marius and Page (2015). The narrative method was used at the beginning of the
paper to help readers appreciate the financial innovation and governance story; with a
chronological ordering of events in a way that allowed for the kind of comparison the
researcher wanted to do in terms of timing (i.e. when an innovation was introduced
and when some mechanism was put in place to govern it). The analytical method was
also applied mainly to the discussion section of the paper to allow the researcher tease
out arguments regarding motivations, types and processes of financial innovation and
its governance overtime.
3 Emergence of financial innovation
3.1 Definition of financial innovation
A review of the literature on financial innovation reveals that most researchers (e.g.
Llewellyn, 1992; White, 1997; Tufano, 2003; Mishra, 2008; Sánchez, 2010;
Delimatsis, 2011; Gubler, 2011; Lerner and Tufano, 2011) define financial innovation
as the creation and popularisation of new financial products, processes, markets and
institutions. Nevertheless, Mention and Torkkeli (2012; 2014) argue that this
definition is narrow thus suggesting a more holistic view of financial innovation
which not only acknowledges changes in offerings, and modifications in structures,
processes, practices and distribution channels, by financial institutions, but also
emphasizes the need for these to lead to some measurable economic or intangible
impact on society. For the purpose of this study, I take the definition of Mention and
Torkkeli (2012; 2014) and that of others mentioned above a step further and define
financial innovation as “
a process, carried out by any institution, that involves the
creation, promotion and adoption of new (including both incremental and radical)
products, platforms, processes or enabling technologies that introduce new ways or
changes to the way a financial activity is carried out
” (Khraisha and Arthur,
forthcoming). With this definition, we argue in another paper (Khraisha and Arthur,
forthcoming) that financial innovation transcends innovations in the financial
instruments category and can come from non-financial institutions; and these are
important characteristics which should be captured in its definition.
3.2 Core financial products
Serving as a hub for financial innovation, Mesopotamian civilisation played an
important role in the development of financial innovation in early history (Figure 1).
During those early civilisations, societies were normally run as gift economies,
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coupled with the practice of the barter trade system. While some individuals gave
valuable goods to family and friends for free, without any formal agreements for
immediate or future rewards, others traded by exchanging their goods for other goods
perceived to be of equivalent value. Thus as far back as 3000BCE, the concept of
commodity money was coined and this allowed individuals to purchase goods and
services using commodities, such as gold, precious metals and cowry shells, which
were perceived to have great value. This ability to trade led to the development of the
most primitive form of financial arrangements, personal loans, typically compensated
with interest (Allen and Gale, 1994; Wyman, 2012) which made the “intertemporal
transfer of value through time”, a key foundation for finance, possible (Goetzmann
and Rouwenhorst, 2005, p.4). Over time, more sophisticated financial arrangements
sprang up; and banking firms were developed in the Mesopotamian Valley leading to
the creation of the first two financial instruments, bank deposits and bankers’
acceptances (Allen and Gale, 1994; Allen and Yago, 2010). A few centuries later (i.e.
between 1700 and 1100 BCE), early forms of annuities were recorded to have been
traded in Egypt (Wyman, 2012).
Like loans, the development of cuneiform records, which is an example of a
contingency claim in Mesopotamian civilisation, presents another important principle
in finance; “the ability to contract on future chance outcomes” (Goetzmann and
Rouwenhorst, 2005, p.5). This reflects the fact that as individuals transferred the
ownership of their monies to the future though financial arrangements, they also
exposed themselves to risks derived from uncertainty in the future. As a result, both
lenders and borrowers could purchase contingency claims by entering into another
financial agreement requiring one party to make a payment depending on the outcome
of some event (Goetzmann and Rouwenhorst, 2005). These systems had their own
limitations, as transactions under the barter system for example could only take place
if a trader could find someone who wanted what he or she had to offer and had what
he or she wanted; a situation normally referred to as the “double coincidence of
wants”. Thus there was a need for a medium of exchange to make trade easy and
early forms of metal money began to emerge by 1000BCE in China. Between 700 and
600 BCE, modern coins were introduced as a way of standardizing money and
facilitating trade in Lydia and Western Turkey (Allen and Yago, 2010; Wyman,
2012). This made it easy for market participants to trade their contractual claims to
third parties. For example lenders faced with unexpected events leading to a sudden
need for cash could sell their loan contract for coins. Goetzmann and Rouwenhorst
(2005) call this the “negotiability” feature of finance and argue that true negotiability
was developed in China with the introduction of paper money in the eleventh century.
Similarly, Allen and Yago (2010) point out that the development of state-backed
paper money in 1024 made finance easier. However, financial arrangements returned
to a primitive state during the Dark Ages and bank deposits and acceptances faded out
of the system (Allen and Gale, 1994).
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Fig. 1.
A historical rise of financial innovation (Adapted from Allen and Gale, 1994,
Goetzmann and Rouwenhorst, 2005, Sengupta and Aubuchon, 2008, Allen and Yago, 2010,
Davies, 2010, Sudhakara, 2012, Wyman, 2012, Murdock, 2014, Malvey et al., 2013 and Reid
and Harrigan, 2013)
Between the twelfth and thirteenth centuries, when commercial practices of the city
states in northern Italy emerged and became sophisticated, society saw a re-
emergence of bank deposits and acceptances in the form of modern banking; and its
use spread widely as trade and commerce grew in Europe (Allen and Gale, 1994).
Furthermore, the rapid development in trade and commerce during this period led to
prosperity and consequently a desire to create more wealth; and capitalism, “a system
based on individual investments in the production of marketable goods, slowly
replaced the traditional ways of meeting the material needs of a society” (Appleby,
2010, p.3). Capitalism was characterized by private ownership, entrepreneurial
control, free competition and the formation of joint stock companies among other
things (Hodgson et al., 2001). Thus there was a motivation to create new financial
products that met the needs of capitalists. By the sixteenth century, two new financial
instruments were introduced to facilitate this; bonds and equities (Allen and Gale,
1994). While the first equity was issued by a joint stock company in Russia in 1553,
the first bond was issued by the French government in 1555 (Allen and Gale, 1994).
Gradually the use of equities and bonds became widespread. In addition to
governments, companies also began to issue bonds, and also developed various types
of securities such as convertibles and preferred stock to meet the needs of investors.
At the same time, the first cheque was introduced in 1659 in London as trade
continued among financial institutions in continental Europe (Davies, 2010). By the
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seventeenth century, the total amount owed to both firms and government had grown
larger; and this necessitated secondary trading and a better organisation of how
financial markets worked. In 1611, the first securities trading market was opened in
Antwerp and Amsterdam (Allen and Gale, 1994). Furthermore, “the development of
organized secondary markets for securities led to sophisticated trading practices
which in turn spurred financial innovations” in the area of financial risk management
in the 17th and 18th centuries (Allen and Gale, 1994, p.13). By the end of the 18th
century, innovation of quite sophisticated and complex financial products and
services had occurred: and this happened in quite a short space of time.
Between the nineteenth and twentieth century, the Roman legal system developed “a
form of de facto depersonalized business entity” (Abatino et al., 2011, p.1) which
recognized the corporation as a legal entity, “with right of ownership and the capacity
to contract with others” (Goetzmann and Rouwenhorst, 2005, p.13). This concept of
the corporate form is seen by Goetzmann and Rouwenhorst (2005) as a financial
innovation in itself as it changed to a great extent practices in the financial sector.
With this new system, business activities were no longer personal, as managing
partners and shareholders held a limited liability in the company. That is to say “no
matter how large the loss incurred by a company, its shareholders would be liable for
no more than the value of their initial investment” (Goetzmann and Rouwenhorst,
2005, p.14). With the invention of the corporate form, coupled with repeal of the
Bubble Act (an act which made it illegal to form a company without a charter (Allen
and Gale, 1994)) due to developments in canal and railway construction and falling
security values (in Britain), financial activity increased, leading to the development of
even more sophisticated types of bonds and equity. Similarly, the USA’s increasing
need for capital due to civil war and expansions in railway construction led to creation
of different types of financial securities (Allen and Gale, 1994). Some of these were
income bonds, commercial paper, warrants and commodity futures exchanges (Allen
and Gale, 1994). Further, the first electronic fund transfer was recorded in a
transaction by Western Union in the USA (Sudhakara, 2012).
After the Great Depression and the Second World War, financial instruments in
common use remained relatively stable. However, between the 1960s and the 1970s,
the pace of innovation quickened tremendously (due to changes in the underlying
technologies of finance (e.g. data processing and telecommunications), deregulation,
changes in the economic environment (i.e. higher and more variable inflation and
interest rates) and the desire of many to circumvent regulation (White, 1997); with
most of the innovations being a further development of some of the traditional
instruments discussed above. Tufano (2003, p.7) argues that this is a “normal pattern
of financial innovation where a security is created, but then modified (and improved)
slightly by each successive bank that offers it to its clients”. For example, firms
introduced floating rate notes, zero coupon bonds, synthetics and poison pill
securities, all of which are types of bonds or equity with different features (Allen and
Gale, 1994). Important financial innovations such as currency swaps developed in the
1960s by UK banks as a way to avoid UK exchange controls (Allen and Gale, 1994)
and securitized loans created in 1970 under the auspices of the US’ Government
National Mortgage Association (GNMA) were introduced.
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The advancement of technology in finance accelerated greatly, leading to the
development of several process-related innovations such as debit and credit cards,
automated teller machines (ATMs) and online/telephone banking systems between
1950 and 1980 (Batiz-Lazo, 2011). During this period, microfinance was also
introduced by the Grameen Bank in 1976 (Sengupta and Aubuchon, 2008). Within a
short time, the concept of securitisation, a process whereby cumbersome, illiquid
financial contracts (e.g. the Russian government bond fund which made available
loan-backed bonds of Russian government debt to smaller investors in Holland in the
nineteenth century) are converted into liquid instruments of smaller denomination that
could be traded on a capital market (Goetzmann and Rouwenhorst, 2005) had been
extended to other assets (e.g. homes, cars, credit card receivables etc.). This led to the
creation of more complex and sophisticated asset-backed securities (ABSs) in the
twentieth century. The collateralised debt obligation (CDO), first created in 1987 in
the USA (Stefani, 2010) is one of such ABSs; and this has since been classified as
‘toxic’ (Longstaff and Myers, 2009) and is seen as a major contributor to the recent
financial crisis (Gubler, 2011). Unfortunately, there is limited information on
innovations that emerged after the year 2000. However, the literature suggests that
between the years 2000 and 2007, the financial sector witnessed a rapid diffusion and
commercialisation of innovations developed earlier in the mid to late 20th century
such as CDOs and subprime mortgages (Arestis and Karakitsos, 2009; Dwyer, 2012;
Murdock, 2012). Further, other major innovations witnessed in the 21st century
includes company specific big data initiatives in the financial sector (Malvey et al.,
2013), financial service technologies (FinTech) startups (Zavolokina et al., 2016), and
the virtual currency, Bitcoin, first traded in 2009 (Reid and Harrigan, 2013).
3.3 Managing financial risk and uncertainty
The emergence of innovations to support risk assessment and pricing in finance dates
back to 2500BC, in the context of good transport insurance (in Babylonia) around the
same time when core financial products were introduced (Wyman, 2012). However,
the proliferation of innovations to support the management of financial risk and
uncertainty largely occurred in the 17th and 18th centuries in response to increasing
sophistication in financial practices (Allen and Gale, 1994). During this period, the
first insurance company was established in London in 1667 (Allen and Yago, 2010) to
protect investors from the risks and uncertainties arising from the introduction of
more complex innovations into the financial system. Further, society witnessed the
introduction of innovations such as the call and put options (introduced in 1636 in
Holland (Sinclair, 2010)), the futures contract developed by the Japanese in 1710
(Reszat, 1997; Wyman, 2012), the mutual fund created by the Dutch in 1773
(Wyman, 2012) and check clearing houses developed in London in 1774 (Wyman,
2012). While options and futures gave investors protection from fluctuating prices
(Smithson, 1998), mutual funds (if managed properly) made it possible for investors
to reduce investment risk (through diversification) (Hu et al., 2014) and clearing
houses (e.g. counter party clearing houses) helped reduce default risk by netting
offsetting transactions (Mehra, 2010; Duffie and Zhu, 2011). Similarly, the creation
of the credit default swap (CDS), created in the mid-1990s (Kolb and Overdahl, 2009)
in the USA, made it possible for financial institutions to insure against third party
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defaults. CDSs have been identified to have contributed to the 2008/09 financial crisis
and to the sovereign debt crisis in the Eurozone (Dunbar and Martinuzzi, 2012). In the
case of the 2008/2009 financial crises, Adam and Guettler (2015) argue that the
destruction was not caused only by the design of the innovation, but also by how it
was governed; that is the use of teams to manage the fund slowed down decision
making processes at a time when market conditions were changing rapidly.
3.4 Summary
Financial innovation has existed since the civilisation of man; however the pace of
financial innovation quickened in the first half of the 17th century, and then again in
the 20th century. Although some financial innovations in history are novel (e.g.
technological innovations like the ATM) and have changed how the industry works,
most innovations, especially in the 20th and 21st century have been further
developments of already existing products and service. Therefore the process of
creating new and/or improved, products and services appears to have been largely
incremental as levels of competition in the industry have increased; and these
innovations have been driven by factors that are both internal and external to the
innovating organization. Complexity, which derives from reconfiguration in a
globalized, socio-technical context, seems to characterize the financial innovation
process, causing high risks and uncertainty. This historical review creates a
background against which the financial innovation governance landscape can be
explored.
4 Emergence of financial innovation governance
4.1 Financial regulation
The history of governance in financial innovation is evidenced in practices such as
the, social and political organisation, called the polis, developed in the eighth century
BC by the Greeks to respond to market conditions and limit the effect of the market
on society ((Redfield, 1986), regulatory problems resulting from forgery and
counterfeiting in the financial system faced by first Roman and then Byzantine States
in the Middle Ages (Levi, 1987), competition identified in early civilisation among
national authorities in order to subject financial actors to their needs and demands
(Germain, 2010) and activities of barter markets centuries ago (Gilligan, 1993).These
suggest that governance of financial innovation extends back many centuries, with
usury laws being the oldest form of regulation (Benmelech and Moskowitz, 2010).
Introduced in 454BCE (Bolles, 1837), usury laws governed aspects of some of the
earliest financial innovations (e.g. banking) by putting in place restrictions on the
interest that could be charged by bankers; and punishments for offenders. This was to
avoid extortion and protect consumers from the negative impact of the lending
system. By the 14th century, governance of previous innovations in finance became a
part of existing legal frameworks as the UK introduced clauses to govern financial
activity in her common law. These legal policies did not govern the innovation
process itself but mainly governed financial activity and the products of innovation
after they had been introduced. Thus financial traders were prosecuted for several
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offences, including engrossing (buying goods to sell in the future at a higher price),
forestalling (raising the price of goods by holding up supplies) and regrating (buying
goods in any market in order to raise price and selling it at a later date in the same
place) (Gilligan, 1993). These practices continued until centuries later (i.e. the 16th
and 17th century), when the need arose for the introduction of more prudential forms
of regulation due to increasing complexity in financial products/services. In 1668, the
first central bank was set-up in Sweden to oversee the issuance and circulation of
currency in the economy (Allen and Yago, 2010). Gilligan (1993) suggests that
government’s increasing demand for short term borrowing coupled with the need for
joint stock companies to fund growth into new markets led to an increase in
marketing of stocks, fraud and manipulation of the market. Thus in 1697, the Act to
Restrain the Number and Practice of Brokers and Stock Jobbers was passed. This, the
first securities trading legislation (perceived as being restrictive, preventive and
punitive), was a piece of process innovation in itself, as it sought to limit the number
of brokers and the commissions paid to them; and to ensure that all brokers were
licensed and transactions carried out were recorded (Gilligan, 1993).
Fig. 1
. Historical rise of governance structures for financial innovation (Adapted from Redfield,
1986, Allen and Yago, 2010, Archarya et al., 2010, Germain, 2010, Omarova, 2010, Komai and
Richardson, 2011, Cheffins, 2013, Her Royal Majesty's Treasury and Javid, 2013)
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The 18th, 19th and 20th centuries saw the emergence of more policies to govern
financial activity in several countries. In New England for example the Currency Act
was introduced in 1751; this act declared paper currency a legal tender (Allen, 2009)
and provided further guidance on the issue and circulation of money. Similarly, the
US Government in 1791 chartered First Bank of the United States to manage the
financial needs of the federal government, credit and coinage of the nation; following
which the country witnessed in 1863 the passing of the National Currency Act
(Komai and Richardson, 2011). In 1873 in Massachusetts, the first standard insurance
regulation (for fire) which focused on licensing and reserve requirements (among
others) was passed; although the industry had governed themselves prior to this
through insurance boards (the first of which was set up in 1855 in New Hampshire)
(Meier, 1988). This was followed by the introduction of the first Banking Act
(sometimes referred to as the Glass-Steagall Act) in 1933 in the USA which sought to
regulate the activities of banks; provisions included the separation of investment from
commercial banking (Garten, 1997; Russell, 2008), restrictions on private banking
activities and the use of bank credit and requirements for banks to have temporary
insurance for deposits (Preston, 1933). In 1929, the USA witnessed the collapse of the
New York Stock Exchange i.e. a sudden decline in stock prices (e.g. a fall of 24% for
the Dow Jones over a period of two days and a total decline of 37% by the end of
November 1929) due to excessive speculation (among other things) which caused
distress to the financial system (Mishkin and White, 2002). This led to the
introduction of the first major piece of federal legislation (in the USA) governing the
issuance, sale and trading of securities as well as futures and options respectively (i.e.
the Securities Act in 1933 and the Commodity Exchange Act in 1936) (Germain,
2010; Komai and Richardson, 2011). In 1988, securitisation was introduced into
French law as a way of governing securitisation reconfiguration of financial assets
(Baums, 1994).
The use of legislation in governing the financial sector worked well until the late
1970s and early 1980s when advancements in technology and communication caused
financial institutions to innovate and find ways around existing regulation (Ingham
and Thompson, 1993). This, among other things, led to a series of de-regulation
initiatives mainly focused on the removal or lessening of interest rate ceilings and the
management of competition among banks (e.g. the introduction of the Competition
and Credit Control Act of 1971 in the UK, the Depository Institutions Deregulation
and Monetary Control (DIDMC) Act of 1980 in the USA, Report of the Campbell
Committee of 1982 in Australia and the 1974-75 liberalisation practices in Japan)
(Adhikary, 1992). Since the 1980s, the financial sector in various countries has
experienced periods of regulation and de-regulation leading to the introduction of new
acts and the amendment or repeal of existing acts (Adhikary, 1992; Sherman, 2009).
In the USA for example, acts such as the Garn-St. German Depository Institutions
Act of 1982 (which allowed commercial lending among savings and loans
institutions), the Financial Institutions Reform and Recovery Act of 1989 (which
strengthened regulatory mechanisms for governing thrifts), the Gram-Leah Bliley Act
of 1999 (which repealed the Glass-Steagall Act of 1933) (Sherman, 2009) and the
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (which
reforms the financial regulatory environment (in response to the 2007-2008 financial
crisis) with a view to improving financial stability and protecting consumers)
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(Acharya et al., 2010) among others were introduced. Similarly, acts such as the
Banking Act of 1979 and 1987, the Financial Services Act of 1986 and the Financial
Services and Market Acts of 2000 have emerged in the UK in an attempt to
consolidate financial services regulation, improve financial stability and protect
consumers (Radcliffe et al., 1994; McConnachie, 2009; Davies et al., 2010). More
recently, the concept of separating investment and commercial banking activities (as
in the case of Glass-Steagall mentioned above) has been proposed by the Independent
Commission on Banking set up by the UK government (following a series of
irregularities e.g. LIBOR scandal) to make recommendations on banking regulation;
and UK financial regulators have, following a bill put through to parliament, recently
in 2013 passed this into legislation (Edmonds, 2013) under the Banking Reform Bill
(Her Royal Majesty's Treasury and Javid, 2013).
Germain (2010) suggests that financial governance went through several changes; and
finally gained prominence in the 19th and 20th centuries. In these centuries, it was
possible to see establishment of international governance systems operating through a
set of linked world markets mainly based in London and central banks across Europe,
Latin America and Asia (Brown, 1940; Williams, 1963; Germain, 2010). This led to
“a new ‘sectoralisation’ of financial governance in which different parts of the
financial system became subject to specific, often statutorily independent, regulatory
agencies” (Germain, 2010: 31). In the USA for example Securities and Exchange
Commission (SEC) was set up to oversee stock exchange regulation (Germain, 2010).
Nevertheless, the financial sector saw a move towards internationally agreed
regulatory practices with the deepening of networking relationships (through
international conferences and organisations/committee e.g. League of Nations) among
financial institutions in the 19th century (Germain, 2010); the collapse of the Bretton
Woods fixed rate system (i.e. a system where exchange rates were determined by
pegging foreign currencies to the US dollar) in 1971(Verdier, 2013) and the
introduction of the Basel Accord (a consensus among 12 countries to impose upon
their international banks a set of minimum capital standards (Van Roy, 2008)) in 1988
(Davies et al., 2010) among others. With the creation of the ‘new international
financial architecture’ (NIFA) (which was a reaction to major financial crisis that took
place in emerging markets such as Mexico in 1994, East Asia in 1997-8 and
Argentina in 2001) (Eichengreen, 1999; Kenen, 2001) in recent years, it can be said
that the scope of international financial regulation is broadening to include non-
western countries.
4.2 Financial self-regulation
Greif (1989) suggests that the history of financial self-regulation dates back to the
11th century where Jewish Maghribi traders in Baghdad used structures built around
incentives of reputational capital and mutual trust to facilitate trade. This was
followed by the voluntary enforcement of courts for settling disputes among
merchants in rural Europe in the 11th and 12th centuries (Benson 1989; Benson
1994). The 19th century saw the introduction of self-regulation in the financial
securities sector, although evidence of how this worked is limited (Centre for
Financial Market Integrity, 2007). The use of this system of governance continued to
increase until the 1930s when the SEC formalized self-regulation and statutorily
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established various self-regulatory organisations (SROs) in the USA (e.g. Financial
Industry Regulatory Authority (FINRA) and national stock exchange) (Centre for
Financial Market Integrity, 2007; Omarova, 2010). By the 1970s, financial
malpractices among US corporations led to an increased interest in internal
governance (by the SEC) and consequently the introduction of concepts of corporate
governance (i.e. “a system by which companies are directed and controlled”
(Governance, 1992, p.15)) into federal law (Cheffins, 2013). This term gained
prominence in the 1990s with the introduction of the UK’s Cadbury Report (Erturk et
al., 2004; Cheffins, 2013) and has since been a mechanism used both internally and
externally to govern organisations (O'Sullivan and Diacon, 1999; Weir et al., 2002;
Hu, 2015). Siepel and Nightingale (2014) suggest that such corporate governance
mechanisms could vary from country to country; in their study where they focus on
the UK and the US, they argue that practices within the US create a broader scope for
‘managerial agency’ (for example when it comes to issues such as shareholder rights)
when compared to the UK. This is an important point to note as they further argue
that such differences in agency is positively correlated with managerial risk taking
where those with greater agency have the potential to take higher risks (Siepel and
Nightingale, 2014).
The 21st century saw the emergence of several open innovation initiatives within the
financial services industry (Schueffel and Vadana, 2015). While innovation in
traditional settings were initiated by and managed solely within a specific
organisation, open innovation encouraged co-creation among multiple stakeholders
such as customers, suppliers, consultants, educational institutions and research labs.
Therefore, innovation contexts changed considerably; thus encouraging changes in
innovation governance mechanisms. In this open innovation setting, governance
mechanisms included internal processes, rules of collaboration, new service or
product development frameworks that are repetitive, corporate culture initiatives,
evaluation methods, and communication and collaboration technologies that fostered
flexibility; all of which were managed by stakeholders, specifically, top management
within the corporate governance framework (Schueffel and Vadana, 2015). Within the
context of financial self-regulation, it is important to note the emerging use of
decentralized forms of governance. A typical example of this is evidenced in the
virtual currency, Bitcoin, which depends on the efforts of multiple people such as
software engineers, users, currency exchanges and regulators in the setting and
enforcement of rules. Bitcoin encourages the use of governance rules embedded in the
design of the product rather than the use of an intermediary or central authority
(Rainer et al., 2015). Therefore, its rules include features in the system’s underlying
software that encourage transparency by making transactions traceable and available
to all in the Bitcoin network, fosters anonymisation of user identity and money flows
through encryption and pooling of transactions and allows users to control the pace of
commercialisation of the virtual currency by correctly solving mathematical puzzles
in order to validate transactions (Rainer et al., 2015). Although such self-regulatory
mechanisms are unique and appear robust, Rainer et al. (2015) suggest the possibility
of lapses in the use of self-regulatory mechanisms such as these; thus arguing in favor
of supporting them with financial regulation for aspects of the virtual currency (e.g.
consumer protection).
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4.3 Summary
While until recently there is no evidence of specific governance mechanisms for the
process of financial innovation itself, governance of the financial sector, in the form
of legal frameworks, policies and self-regulatory mechanisms, dates back many years
in history. These governing systems mainly focus on financial activity, using internal
and external structures and placing emphasis on the regulation of the products of
financial innovation after these had been developed and implemented, sometimes
many decades or even centuries after this had occurred. Throughout history,
governance systems of the financial sector have continued to be restrictive, evolving
from being a national activity using a consolidated system to an international activity
organized on a sectorial basis. This trend is however changing and society is
witnessing a centralization of financial sector governance and an increased focus on
financial stability and consumer protection in terms of objectives. I now proceed to
discuss lessons learnt in history with regard to the emergence and governance of
financial innovation.
5 Discussion
5.1 Motivations for and drivers of financial innovation
It can be argued that the introduction of money, interests, personal loans, banking
firms, contingency claims and all the products associated with lending during
Mesopotamian civilisation were introduced as demand increased for these products.
This suggests that financial innovation started out as a need - based activity to support
trade and enterprise; where financial products, services, and institutions were
developed because the need for the product/service already existed, or was created by
the innovators. Nevertheless, other factors such as technological advancement,
civilisation and consequently the changing needs of man contributed to the
continuous improvement of original innovations. Unlike practices in Mesopotamian
civilisation (where financial innovations were introduced to profit from trade and
enterprise), capitalism introduced a system where money itself became the
commodity and profit from trading money rather than non-financial products and
services gained emphasis i.e. a move from money as a facilitating agent to money as a
tradable commodity that generates profit in itself. This was because society saw
massive developments in terms of ownership of private property and means of
production among governments and owners of large corporations and financial
intermediaries. According to Ferguson (2008) the desire for governments to provide
for and support their wars was a major driver of financial innovation in this era. In the
cases of Germany, Russia and Austria for example, the countries suffered bad
currency collapses and hyperinflation resulting from huge debt mountains they
couldn’t honour as a result of wars; hence the need to develop various financial
instruments to raise additional capital. In the case of large corporations financial
innovation was driven by the desire to increase profits; and the case of the Medici and
Rothschild brothers who, by actively participating in the evolution of banking, made
tremendous financial gains for themselves and their families is a good example
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(Ferguson, 2008). Therefore, the introduction of market economies, various types of
financial institutions, stock exchanges, options, futures, forwards and swaps can be
said to have been stimulated by the desire to increase wealth while minimizing the
risks associated; thereby supporting arguments by Laeven et al. (2015) that financial
innovation is the output of decision making processes by profit maximizing
individuals. Nonetheless, it is also clear, as can be seen from the repeal of the Bubble
Act and the introduction of the corporate form, that some of the developments in
financial innovation during this stage were a result of changes in the regulatory
environment.
With regard to financial innovation in the 21st century, there seems to be a slight
change in motivations and drivers. This is because most of the financial innovations
that have taken place within this period have been minor variations of already existing
products, services and institutions. In a paper exploring the perceptions of banks’
senior managers and management consultants on the factors stimulating and
constraining the adoption of new technology in financial intermediaries in the UK,
Batiz-Lazo and Woldesenbet (2006) found that innovation in banking is largely a
process of incremental change that modifies both banks’ internal and external
environments. Thus Graham and Dodd (1934) identify 258 financial securities; all of
which are bonds, shares and warrants with slight differences in characteristics and
risks. To this end, it might be suggested that in the 21st century, the vast majority of
financial innovations are driven by competition where financial institutions need to
differentiate their products by providing options and flexibility in order to survive,
thrive and win. Further it could be argued in line with Su and Si (2015) that financial
innovations in the 21st century were also made possible due to the existence of
national contexts that promoted economic freedom. However, there is limited data to
allow for an investigation into whether there are any performance aspiration effects.
In conclusion, it can be argued that the main drivers of financial innovation are found
to have evolved from need to profit and competition. However it is worth noting that
none of these factors have worked alone. Allen and Gale (1994) show that financial
innovations were also stimulated by social, cultural and political factors.
5.2 Types of financial innovation
From the historical review above, it can be argued that financial innovation can
generally be grouped under four main headings; 1) Products 2) Platforms, 3)
Processes and 4) Enablers. These four categories are not mutually exclusive and could
be intertwined in many respects (see Table 1).
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Table1.
Typology of financial innovation based on historical review
PRODUCTS
PLATFORMS
PROCESSES
ENABLERS
Cash Instruments
Savings Accounts
Checking Accounts
Money Market
Accounts
Certificates of
Deposits
Interbank Deposits
Debt and Equity
Instruments
Loans
Notes
Bills
Bonds
Stocks
Microfinance
products
Private equity
Derivative
Instruments
Forwards
Future
Options
Warrants
Swaps
Credit Default
Swaps
Mortgage-Backed
Securities
Collateralized Debt
Obligations
Insurance and
reinsurance
products
Commercial Banks
Investment Banks
Central Banks
Fractional Reserve
Banking
Mutual Funds
Clearing Houses
Stock Exchanges
High Frequency
and Algorithmic
Trading Platforms
Secondary
Mortgage Markets
Venture Capital
Firms
Hedge Funds
Blockchain
Technology
FinTech Startups
Asset Management
Funds
Exchange Traded
Funds
Pension Funds
Mobile Network
Operators
Finance Companies
Automated Teller
Machines (ATM)
Online, Telephone
and Mobile Banking
Consumer Online
Stock
Trading
Point of Sale
Terminals
Debit and Credit
Cards
Improvements in
Financial
Management and
Reporting Practices
New Customer
Service Processes
within Financial
Institutions
Monitoring
Diversification
Relationship Banking
Private Banking
Wealth Management
Risk Management
Procedures
Non-Bank Credit
Intermediation
Crowd Funding
Risk Culture
Risk Sharing
Techniques
Securitization
Syndication
Loan Trading
Trade Finance
Islamic Finance
Financial Theory
Econometrics
Portfolio Theory
Efficient Markets
Theory
Capital Asset
Pricing Model
Black-Scholes
Merton Model
Risk Adjusted
Return on Capital
Duration Analysis
Sensitivity Analysis
Value At Risk
Expected Shortfall
Financial
Technology
Software and
Information
Technology
Computational
Power of
Computers
Data Collection and
Telecommunication
Regulatory
Innovations
Limited Liability
Capital Adequacy
Requirements
Deposit Insurance
Ongoing Research
and Development in
Finance
Financial Indices
Product financial innovations as those innovations that serve as tools for carrying out
financial transactions. These include a wide range of cash, debt, equity and derivative
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instruments as well as insurance and reinsurance products. While cash instruments
comprise certificates of deposits, interbank deposits and savings, checking, money
market and time deposit accounts, debt and equity instruments include loans, notes,
bills, bonds and stocks and vary depending on characteristics such as risks and
payoffs involved and how payments are to be made among parties. On the other hand,
derivative instruments consist of forwards, futures, options, warrants and swaps that
vary based on the type of underlying asset, the market in which they trade and the
payoffs while insurance and re-insurance products include packages introduced to
help individuals and firms pool and diversify risks. Platform financial innovations are
defined as those innovations that provide a place for financial activity to take place.
They are institutional in nature and include, but are not limited to, banks, financial
markets, clearing houses, Blockchain and Fintech start-ups that normally emerge to
improve the efficient use of, and create opportunities for using, product innovations.
Process financial innovations are those innovations that involve the creation of new
ways or the introduction of changes in how a financial activity is carried out and
delivered. This includes significant changes in techniques, equipment and/or software
used in distributing securities, processing transactions, or pricing transactions. They
relate not only to radical (often technology based) innovations (such as Automated
Teller Machines (ATMs), online banking, electronic trading and securitisation among
others) that transformed the financial sector but also to incremental innovations
carried out by organisations to improve how things work; what Mention and Torkelli
(2012, p. 11) describe as “modifications to internal structures and processes,
managerial practices, new ways of interacting with customers and distribution
channels” within financial service firms. An example of this regards the use of e-
transparency initiatives by financial institutions to facilitate financial reporting and
information dissemination as required by law (Railiene, 2015).
Innovations within the final category (i.e. the enablers) are defined as those
innovations that facilitate advancements in the other three categories. Enabling
financial innovations are not per se the end of financial markets, in the sense that they
are not the final product to be sold and exchanged. However, they have led not only to
the creation of new financial products, platforms and processes but also new ways of
using already existing financial innovations. The importance of enablers as a class of
financial innovations derives from the fact that financial innovations have shown to
follow what Carlota Perez called ‘Technological Revolutions’. Each technological
revolution brings about new enabling technologies that trigger the development of
new financial innovations (Perez, 2003). Therefore, they deserve to be acknowledged
in the financial innovation typology. The most notable financial enablers are the
proliferation of sophisticated mathematical models (e.g. Louis Bachelier's theory of
speculation, Markowitz mean variance of portfolio selection model, the Capital Asset
Pricing Model (CAPM), the Black-Scholes (1973) model for options pricing and the
Gaussian copula model for probability distribution which has become central to
modern finance (particularly investments and capital markets) in the last two decades
(Merton, 1995b). These models played a significant role in the advancement of
innovations within the derivatives, risk management, asset management,
diversification, investment banking and corporate banking industries.
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5.3 Process of financial innovation and associated stakeholders
According to the review above, financial innovation appears to have occurred within
a process of idea generation to launch with limited understanding of what happens
between these two end points, among internal and external stakeholders and
associated lead times; thereby suggesting the use of an unstructured approach to
innovation. Although some financial innovations in history are novel and have
changed how the industry works, most innovations, especially in the 20th and 21st
century have been further developments of already existing products and services.
Thus ideas generated at the conception stage of the innovation process have evolved
from radical, ‘do different’ strategies to smaller, incremental changes. For instance,
while financial innovations in early civilisation (money, early forms of bonds, stocks
and exchanges), were found to have caused a dramatic effect on the nature and scope
of financial activity, recent innovations, especially in the derivatives and securities
sector, follow Merton’s innovation spiral principle i.e. a situation where the creation,
of one financial product leads to the creation of a new financial product (Merton,
1992). This process is made possible, for example, due to the interaction between
financial intermediaries and markets and the effect of cost reduction they benefit from
innovation; as products created by financial intermediaries get standardized, new
trading markets are created and this in turn leads to the creation of new financial
products as financial intermediaries further trade in these new markets (Merton,
1995a). Therefore, recombination, incremental adaptation and increasing complexity
are identified as key features of the financial innovation process. This involves both
internal and external stakeholders including corporate institutions, governments and
individuals who interact and collaborate with each other; thus suggesting an element
of co-innovation (Lee et al., 2012) within the innovation process.
5.4 Process of and mechanisms for financial innovation governance
Findings from the review show that there are few accounts of specific mechanisms for
the governance of financial innovation itself. What exists is governance of the
financial sector which focuses on ensuring law and order in financial activity rather
than (Germain, 2010) rather than the development of financial innovations from
inception to commercialisation (Asante et al., 2014); and these are predominantly
monitored and enforced using legal codes. Nevertheless, if issuance, as used to
describe the various legislations above, refer to circulation, then it can be argued that
although no evidence of specific regulations for the creation of financial innovation
exists, some legal frameworks have been put in place to govern its popularisation; but
these were imposed sometime after the innovation had occurred and become
embedded in practice. Further, Bettzüge and Hens (2001) argue some financial
innovations do not become standard instruments of financial trade since they
disappear as quickly as they emerge. For example the financial innovation process in
early civilisation saw the introduction and disappearance of several products, with
some re-appearing at a later date in slightly altered form (Allen and Gale, 1994). Thus
there could have been informal mechanisms in place to govern the financial
innovation process (i.e. amend those innovations or withdraw them from the system);
although evidence of this is limited due to lack of information.
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It is visible from the discussions above that financial sector governance is most often
reactive rather than forward looking (Pol, 2009; Germain, 2010; Pacces, 2010);
normally occurred in response to a crisis (Cox, 2008; Helleiner and Pagliari, 2010);
and comprising extensive government involvement (Helleiner, 1994; Eichengreen,
1996) (e.g. as central banks were thought to be incapable of regulating the financial
system after the 1929-1931 financial crisis (Germain, 2010)). These suggest that
financial sector governance (both financial regulation and financial self-regulation)
lags financial innovation itself (Owen et al., 2009) and an attempt to address the
impacts of an innovation is normally based on hindsight and not foresight. Thus
although major legislations (under financial regulation) were in place to govern basic
financial products/services by the 1980s, a series of amendments of these (in the form
of several acts after this period were necessary in order to address issues brought to
the forefront by various financial crises and scandals (Gilligan, 1993). This has
resulted in an increased focus on maintaining financial stability and protecting
consumers in terms of the objectives of financial sector governance.
6 Conclusions and contributions
I am left with the impression that the current state of knowledge of financial
innovation and its governance is very limited. While studies in the field have engaged
in discourses centered primarily on the “back-end” of the innovation process (e.g. the
diffusion of innovation, the characteristics of adopters, and the impact of innovation
on firm profitability) (Frame and White, 2004), this paper has contributed to calls by
these authors to develop a more comprehensive understanding of financial innovation
and its governance. My point of departure for the study was to make the argument
that an understanding of how financial innovations have occurred and been governed
could shed more light on the topic. Although a review of the literature show that some
of the historical mapping of financial innovation exists (e.g. Allen and Gale, 1994,
Allen and Yago, 2010), none combines this with aspects of their governance,
regulatory or otherwise and a comparison of the two is necessary to enable
researchers understand the extent to which governance mechanisms used in the past
are robust to ensure the responsible emergence of financial innovations.
Findings from this review show that there is huge diversity within the financial
innovation landscape with innovations spanning a myriad of activities. These are
normally driven by factors such as need, profit and competition which have changed
overtime. The innovation process per the review is also identified to be largely
unstructured. Nevertheless, this may be more of an information void rather than a
management void that may need to be addressed by more open and transparent
articulation of internal innovation management approaches by stakeholders to the
public. The review also suggests the financial innovation process to be characterized
by multiple stakeholder involvement, recombination, incremental adaptation and
increasing complexity.
It is important to note that findings from the review brings to bare the lack of specific
governance mechanisms for the development and commercialisation of financial
innovation. What existed was legislations targeted at the governance of financial
activity in the sector with the introduction of legislations lagging the development and
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implementation of financial innovations themselves. Thus I could conclude that
approaches to governing financial innovation throughout history were insufficiently
robust to support the responsible emergence of financial innovations in society; hence
the proliferation of financial crises and scandals in the financial innovation and
governance narrative.
7 Limitations and Areas for Further Research
This review paper has sought to investigate the extent to which mechanisms for
governing major financial innovations through history are robust in supporting their
responsible emergence in society. Nevertheless, it is important to note that the use of
timing of governance in relation to when innovation was introduced is only one way
of measuring robustness; thus posing a major limitation to the study. In other studies
(Asante et al., 2014; Arthur, 2017), I suggest use of the dimensions of responsible
innovation being developed in the literature as another approach to measuring
robustness of governance mechanisms. Therefore further studies that relate the
innovation governance processes and mechanisms identified in this study to
dimensions such as anticipation, reflection, deliberation and responsiveness suggested
by Owen et al. (2013) would be beneficial. Further, validation of the features of
financial innovation deduced from the review through empirical study within
institutions across a wide range of sub-sectors in financial services is necessary if we
are to consider the feasibility of a general theory on responsible financial innovation.
Additionally, it is important for use to investigate whether financial sector governance
subsumes financial innovation governance in a satisfactory way as findings from the
review also indicates that legislation could play an indirect (contextual) role in the
framing of innovation trajectories
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