Embedding financial innovation governance into legislation – the European Banking Authority (EBA)

Financial-Reform1

The European Banking authority is one of the few regulatory bodies that have recognized the need to embed financial innovation governance into legislation. See news items below:

Financial Innovation and Consumer Protection

01 February 2012
The EBA publishes today an overview of the objectives and work of the EBA’s Standing Committee on Financial Innovation (SCFI) in 2011-2012 in the area of consumer protection and financial innovation.

The regulation establishing the European Banking Authority (EBA) requires the establishment of a Committee on Financial Innovation (article 9). The main objective of the EBA‟s Standing Committee on Financial Innovation (SCFI), which was established in May 2011, is assisting the EBA in fulfilling its mandate in the areas of financial innovation and consumer protection, as described in article 9 EBA regulation.

From 2012 onwards, the EBA will publish a yearly report, prepared by the SCFI, identifying areas of concern in both the consumer protection and financial innovation areas of the banking sector, as well as areas where these two intersect. This will include recommendations to EBA‟s Board of Supervisors (e.g. for EBA to do further work or to take corrective or restrictive action), to national supervisory authorities (e.g. to further examine or address an issue locally), or to the Commission (e.g. for regulation).

The European Banking Authority was established by Regulation (EC) No. 1093/2010 of the European Parliament and of the Council of 24 November 2010. The EBA has officially come into being as of 1 January 2011 and has taken over all existing and ongoing tasks and responsibilities from the Committee of European Banking Supervisors (CEBS). The EBA acts as a hub and spoke network of EU and national bodies safeguarding public values such as the stability of the financial system, the transparency of markets and financial products and the protection of depositors and investors.

Source:http://www.eba.europa.eu/Publications/Consumer-Protection-issues/Financial-Innovation-and-Consumer-Protection.aspx

Link to overview of work report: http://www.eba.europa.eu/cebs/media/Publications/Consumer%20Protection/EBA-BS-2012-003-Financial-Innovation-and-Consumer-Protection–Overview-of-EBA-work-in-2011-2012.pdf

Do we need new controls, or should we improve the effectiveness of existing ones?

The following article ties in perfectly my research, thus I felt i should share.

WEF urges new controls on financial innovations

Sarah Krouse

27 Apr 2012

Financial innovations, blamed for exacerbating the financial crisis, still face a major perception problem, but a new report says that they should continue to be developed – with better controls.

Photo credit: World Economic Forum, Andy Mettler

Photo credit: World Economic Forum, Andy Mettler

The study, published on Friday by the World Economic Forum and consultancy Oliver Wyman, outlined steps that firms and regulators should take to ensure the responsible development of financial innovations – which include products such as collateralised debt obligations and credit default swaps. The WEF urges stress tests, market trials and changes in incentive structure to stem potential negative outcomes.

At the report’s centre is an outline of the fundamental issue with new products: that they have no track record and therefore no historical data that can be used for reference. The group encouraged testing that acknowledged unknowns and anticipated potential problems.

It also called for more ‘extreme scenario’ stress tests and intervention when products mutate in the markets in potentially dangerous ways.

Banks and other institutions have the responsibility to adjust their enterprise risk management systems to account for risks from new products, educate their boards about new innovations and revise their new product approval processes, the report said.

New approval processes should include market trials similar to those used by the pharmaceutical industry, giving more attention to innovations that come from existing products, and better tracking of products in the market throughout their lives and as they become more widespread.

Regulation should have a lighter touch, allowing for new innovations, the report said, but its authors encouraged collaborations so that both regulators and institutions understand new risks.

To avoid incentivising inappropriate selling of products, as many mortgage brokers were accused of in the boom, the study recommended clawbacks and deferring incentives for products with longer lives, perhaps spreading bonus payments over three to six years

The group also called for an overall “customer orientation” with simple, transparent products appropriately matched to clients’ needs.

By identifying potential negative impacts during the development of new innovations, the groups said they hoped “that the industry will continue to be granted the latitude and enjoy the self-confidence to pursue innovation as a path to individual profit, to industry profit and to wide societal benefits.”

Source: http://www.efinancialnews.com/story/2012-04-27/world-economic-forum-calls-for-responsible-innovation

My Thoughts                                                                                                                   Reading this article, I am forced to ponder whether we need new controls, or have to strengthen the effectiveness of existing ones. A review from the literature on structures for governing financial innovation currently suggest that there are quite a lot of controls in place for governing financial activity. Although these do not target regulating the innovation process specifically, it how innovations once they have been commercialized are used. These governance mechanisms are normally regulations enforced externally (by legal sanctions through self-regulatory  and independent governmental organizations) or internally using corporate governance structures. Considering that mechanisms have always existed to govern financial activity, I am of the opinion that there is more of a need for strengthening the effectiveness of controls to govern financial activity. Nevertheless, new controls that monitor the innovation process must be introduced.

Mapping out the financial innovation Landscape

complexity

Where do most financial innovations occur? What are the processes followed for financial innovation? Who are the stakeholders involved in the financial innovation process? These are some of the questions I have been investigating recently in order to describe and map out the financial innovation landscape. My findings from reviewing the secondary literature seem to show that complexity and reconfiguration are emerging themes in the financial innovation process. It is no shock therefore that financial innovations especially in the 20th and 21st century have mainly been about using already existing instruments, practices and technologies in new ways. The unbundling of risks and characteristics of already existing products to form new combinations has also been another major approach that has contributed thousands of financial innovations to society today.

Financial innovations are not confined to just one quadrant of Francis and Bessant’s 4Ps framework (product, process, position and paradigm) for exploring innovation space.  However it seems most financial innovations are sat at the product and process quadrants. To this end,  organizations seem to use aspects of new product/process development approaches coupled with stage gating techniques when creating financial innovations. With regard to stakeholders, a complex interactive web has been identified to exist. This is because, most stakeholders (individuals, financial institutions, non-financial institutions, technology-related institutions, governments etc.) play multiple roles (e.g. innovators, end-users, intermediaries etc.) at different times and at the same time. In summary it can be said that the financial innovation landscape is poorly characterized as no formal model for financial innovation exists.

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