Posts tagged: financial innovation

Mapping out the financial innovation Landscape


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.

How Goldman Sachs helped mask Greece’s debt


The 2,500 year-old Parthenon – still standing while Greece crumbles

Yesterday European finance ministers agreed a second bailout for the Greek Government, worth more than 130 bn Euros. In light of the country’s staggering debt, and the risk it poses to the health of the entire Eurozone, it now appears that Greece should not have been permitted to join the Euro in the first place. So, why was it?

Nick Dunbar’s film on last night’s BBC Newsnight set out to provide at least part of the explanation.

The film shed new light on a slight of hand orchestrated by the investment bank Goldman Sachs, that allowed a large chunk of Greek public debt to seemingly disappear, and for the country’s finances to appear in better shape than they were in reality.

Back in 2001, the Greek government was pondering how it could meet the conditions of Euro membership. A key requirement of the Maastricht criteria, five criteria that determine whether an EU country is ready to adopt the euro, was that member states show ‘directionality’ in their public debt.

This meant that the country’s debt ratio needed to be going down year on year: ‘The national debt should not exceed 60% of GDP, but a country with a higher level of debt can still adopt the euro provided its debt levels are falling steadily’.

The solution they came up with was not to cut spending or raise taxes, as Dunbar incredulously points out, but to attempt to hide their debt. Enter Goldman Sachs, global investment banking and asset management company.

Newsnight revealed that one of the Goldman Sachs bankers hatched an ingenious plan to strike a financial deal called a ‘swap’ with the Greek Government, using it to hide 2.8bn Euros of national debt. The deal was legal but completely secret.

Back in 2003, Nick Dunbar revealed the existence of this deal. Far from ‘making something out of nothing’, as the Greek authorities alleged, Dunbar was very much on the right track. The new revelation made in last night’s film was that of the role played, or perhaps more accurately not played, by the European accounting agency, Eurostat.

Goldman Sachs passed Newsnight an email showing that they covered themselves by discussing the deal with Eurostat. Eurostat dismiss this discussion as having only concerned ‘general clarifications’, and maintain that they only became aware of the deal in 2010.

But regardless of exactly when European institutions, such as Eurostat, became aware of this deal, major concerns remain over why more attention was not paid to the employment of untested and unregulated financial products by European States. emerging from the innovation boom in the banking sector.

The deals were commonplace, Goldman Sachs said in their statement to Newsnight: ‘The swaps were one of several techniques that many European governments used to meet the terms of the [Maastricht] treaty.’

Last night’s film gained access to one of the key figures responsible for the deal, Christoforus Sardelis, then head of the Greek Public Debt Management Agency. He had been tasked with the job of bringing the national finances in line with Maastricht criteria.

With hindsight, it’s apparent to Sardelis that the deal was problematic. Under its terms, Goldman Sachs has made millions from the Greek government, yet the original 2.8bn Euros of debt has now ballooned to 5.7bn Euros. Nevertheless, this is a drop in the ocean of Greece’s £350bn debt.

To Sardelis, the deal may have been a bad one, but it wasn’t the cause of his country’s current woes, he says in the film. ‘It was a very sexy story, between two sinners, but the European crisis is not the child of the sex we had with Goldman Sachs’, he, rather salubriously, commented.


What is financial innovation?


According to the Oxford Dictionary, the term finance can be used as both a noun and a verb in slightly different ways. While it refers to the monetary resources of a state, organization or person when used as a noun, it can also mean, not only providing funding for a person or an enterprise, but also managing effectively large sums of money when used as a verb.  Despite the slight variations in what the concept of finance means, it is evident that money is a key factor in finance; thus it can be said that the history of finance, spans thousands of years into history, starting from when the concept of money was introduced. To this end, it can be argued that financial innovation has been since the existence of man; and the advance of civilization has played a great role in its development overtime.

Although we mostly tend to think about financial instruments for investments (such as bonds, stocks, options, swaps, futures and other structured financial products) when the term is used, it actually encompasses a lot more to include process management products and services such as point of sale terminals, debit and credit cards, credit scoring, electronic trading and on-line, mobile and telephone banking among others. In general innovation theory, most researchers have highlighted the element of “newness” as key in defining innovation. However, in practical terms, it can be said that nothing is entirely new in itself. Thus experts in financial innovation explain that financial innovation involves not only the creation and popularization of new financial products, processes, markets and institutions, but the unbundling and reassembling of the characteristics and risks of already existing instruments to form different combinations. It is interesting to note that financial innovations are largely incremental but very complex and globalized. Therefore the riskiness of financial innovations do not derive from the creation of radical innovations, but from the development of several incremental improvements to already existing products in a very complex and globalized context.

Surprisingly, research undertaken so far suggest that the financial innovation landscape is poorly characterised and no model of financial innovation exists. This is quite alarming as we cannot attempt to address the negative concerns of financial innovation without understanding the process within which it is developed. Probably, we can take clues from the new products/service development process in financial institutions as a way of developing a model for financial innovation as a whole. To this end, it can be inferred that the financial innovation process has similarities with the traditional stage-gate model, comprising four or five stages (e.g. problem recognition, concept development, market research and assessment, concept testing and implementation). Nevertheless, financial innovation differs slightly as it involves what is known as the “innovation spiral”; a process where one financial innovation begets another. Further, financial innovations normally have a short lead time, with development and commercialization taking place within months and days respectively. These suggest that the financial innovation process is a complex one; and this is probably a justification for why a model of financial innovation, does not seem to exist at the moment.

Financial Innovation and the Dilemma of Control


Innovation has been with us for a long time, and its overall contribution to finance and welfare has been positive. Nevertheless, its core benefits to society have recently been questioned following the financial crisis in 2007/2008; where financial innovation has received various criticisms from the media, the public, policy makers and top economists in society. As a result, controversies exist on the merits and dangers of financial innovation; and on the responsibility or irresponsibility with which it is conducted. To this end, there are agreements among stakeholders on the need to create a more responsible approach to handling financial innovation; and actors have become interested in finding ways to preserve the benefits of financial innovation, while at the same time limiting the effects of financial innovations that prove harmful.

Is this a realistic and attainable goal? Do we have a choice if we are to ensure that the financial crisis is not repeated again? Can stakeholders distinguish beneficial innovations from harmful ones early enough to reduce, if not eliminate, the negative impacts of financial innovations? Here the issue is one of uncertainty, ignorance and the dilemma of control; and clearly, this is not an easy task as researchers point out that for most economic and financial decisions, we do not know what all the consequences of the outcome will be; and as such will be exposed to some degree of uncertainty regarding the wider impacts of financial innovations.

The complexity of this issue is even more aggravated when it is understood that financial innovation, comparable to many forms of technological innovation, may be commercialized even before relevant authorities can consider their danger, or even know about their existence. This may also be compounded by the rapidity and complexity of financial innovation itself . Thus, a dilemma of control, may emerge; as by the time undesirable consequences become visible, the innovation is locked in; and making a change has become expensive, difficult and time consuming. These arguments lead to questioning how adequate or robust current mechanisms, including regulation, for governing financial innovations are in predicting the wider impacts of financial innovations before they occur.

Research suggests that financial regulation lags financial innovation itself as regulation in the financial industry have normally focused, to a large extent, on filling in the regulatory gaps identified after each financial crisis. Significant time lags of this type are common for many forms of innovation; and this suggest that experiences in anticipatory governance, and emerging concepts of responsible innovation in these other fields may have read across to the governance of financial innovation. These suggest that financial innovators cannot predict all the possible consequences of their innovations before commercialization; thus the key to addressing the issue of the dilemma of control may be in making the right decisions under conditions of uncertainty, and establishing a framework for responsible financial innovation to support this.

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