Financial Innovation: Concepts and Drivers
Concepts
Financial innovation is defined as the emergence, diffusion, and popularization of new financial instruments, as well as new financial technologies, institutions, and markets. In other words, financial innovation refers to the process of creating new financial or investment products, services, or processes. These advances include innovations in technology, risk transfer, and credit & equity generations. Recent financial innovations have included crowdfunding, mobile banking technology, and remittance technology.
Tufanu(2003) describes financial innovation as new financial products, services, production processes, and organizational forms that reduce costs, lower risks, or provide enhanced products/services/investments that better meet market participants’ demands. Awrey(2013) analyzes the demand-side and supply-side incentives for financial inclusion. The demand-side incentive for financial inclusion reflects the rational response to market imperfections in the form of taxation, regulation, information asymmetry, transaction costs, and moral hazard. For example, investors’ demand for diversification, risk hedging, or higher yield in low-interest rate periods fosters the introduction of new financial derivatives and structured financial investments (Tufanu, 2003). The supply-side incentive for financial innovation arises from financial intermediaries when they meet clients’ demands, mitigate regulations, and impart and recreate their monopolistic situation. With rational participants, financial innovation can benefit the financial system by enabling market completeness, mitigating market friction, boosting the quality and variety of financial services, enhancing risk diversification, and improving market efficiency ( Beck, et al. 2016).
The growth of financial innovation is crucial in the banking system, as it enables banks to diversify their product offerings and adapt to changing market conditions thereby enhancing their competitiveness and profitability.
Principles of Financial Inclusion
The principles of financial innovation can be broadly classified into:
- Efficiency- Financial innovation boosts efficiency in streamlining financial services and reducing costs.
- Transparency- Novel financial instruments and systems seek to provide clever information to consumers and regulators.
- Resilience- A well-structured financial system is robust enough to withstand shocks and efficiently allocate resources.
- Integration- Financial innovation ensures that financial services are accessible to marginalized groups.
Drivers of Financial Inclusion
The drivers of financial innovation in the banking system are multifaceted, and understanding them is crucial in predicting and assessing the effects of financial innovation. There are two drivers of financial innovation: internal and external. Internal drivers consist of organizational structure and strategies. External drivers include the regulatory environment, competitive landscape, and technological advancements.
Regulation is a crucial driver of financial innovation in the banking system. Banking regulations significantly impact the types of products and services that banks can offer their customers. For example, Basel II and III regulatory frameworks introduced new capital and liquidity requirements, which led banks to develop new financial products and services to meet these requirements.
Competition can motivate banks to develop new financial products and services to meet customers’ demands. Increased competition can also lead to the emergence of new players, including fin-tech companies, which can introduce new and innovative financial products and services.
Technological advancements have enabled banks to develop new financial products and services, streamline their processes, and expand their reach. For example, cardless ATM transactions, contactless payments, and mobile loans have all emerged as a result of technological advancements. The growth of financial innovation in emerging markets is the result of technological advancements.
The nature of the driving force of financial innovation in developed and developing countries differ. In developed countries, regulation and competition are the primary drivers of financial innovation. In contrast, developing countries are more driven by technological advancements due to the potential for leapfrogging traditional banking structures. In emerging economies, financial inclusion has played a critical role in promoting financial inclusion, improving access to credit, and fostering economic growth.
In developing countries, traditional banking infrastructure often needs to be developed non-existent, providing an opportunity for the rapid adoption of innovative financial innovation. For example, the introduction of mobile money services such as M-PESA revolutionized Kenya’s financial sector, providing financial access to millions of people who were previously unbanked. Similarly, the introduction of Aadhaar, a unique identification number, has enabled the creation of digital identities that facilitate access to financial services, including bank accounts, insurance, and credit. This has contributed to India’s economic growth by promoting entrepreneurship and job creation.
It is also observed that the emergence of new fin-tech companies in Germany introduced innovative solutions such as digital banking platforms and peer-to-peer lending. This has been driven by both regulatory changes aimed at promoting competition and technological advancements in the financial sector.
To promote financial innovation as a means of driving economic growth and promoting financial inclusion, the Chinese government has made concerted efforts in regulatory changes with a view of encouraging the development of new fin-tech companies and the introduction of innovative financial products such as mobile payment platforms, introduction of blockchains and digital currencies.
Overall, these examples illustrate the complex interplay between regulatory changes, competition, and technological advancements in driving financial innovation in different countries and regions.
References
Awrey, D. (3013) Toward a supply-side theory of financial innovation. Journal of Comparative Economics, 41(2), 401-419.
Beck et al. (2016) Financial innovation: The bright and the dark sides. Journal of Banking and Finance, 72(3), 28-51.
Tufanu, P. (2003) Handbook of the economics of finance. EconPapers, 1(1), 307-335.
