Towards risk free financial sector innovation
Technology and innovation are words that frequently crop up in discourse on the financial services industry. The words are used interchangeably and appear to have lost their uniqueness. Do they have the same meaning? The American Heritage Science Dictiona
The latest instalment on innovation in the financial services industry is courtesy the World Economic Forum (WEF) that, in collaboration with global management consulting firm Oliver Wyman, released a report titled Rethinking Financial Innovation, Reducing Negative Outcomes While Retaining the Benefits. The report considers financial services innovation and its impact on the wider economy. Industry stakeholders view innovation both positively and negatively. “The world is currently facing a conundrum: on the one hand, financial innovation is broadly beneficial and is needed to address many of society’s challenges; on the other, negative outcomes associated with financial innovation are too serious to ignore,” observed Giancarlo Bruno, Senior Director and Head of the Financial Services Industry, WEF.
The pros and cons of innovation
“The report takes the position that the primary responsibility for improving the management of financial innovation lies with banks and insurers,” said Stefan Lippe, former Swiss Re CEO and Chair of the report Steering Committee. “It provides [insight into] potential negative outcomes and recommends initiatives for companies, industry bodies and regulators.” South African banks and insurers are already hard at work to implement post-financial crisis legislative changes to keep pace with their developed world peers.
How do you separate good innovation from bad? The report identifies four areas where “positive innovation” can provide opportunities, including financing and growing the private economy; promoting inclusiveness; improving efficiency, access and the customer experience, and rebalancing risk across sectors of the economy. Turning to our mobile banking example, we have an innovation that satisfies three of these criteria. It has contributed to massive improvements in the South African economy by extending affordable transactional banking services to the previously un-banked!
It is more difficult to single out “negative innovation” events. The executive summary of the report concludes that certain financial innovations were centrally involved in the events leading up to the 2008/2009 financial crisis and ensuing recession! But the complex financial instruments that were at the heart of the sub-prime collapse were welcomed as innovative when first introduced. It seems some innovation occurs for the good of the industry (and the financial sector executives) rather than society at large. These innovations include interest rate futures (1975), stock index futures (1982), insurance-linked securities (1992), credit default swaps (1994) and longevity bonds and swaps (2004) to name a few.
Assigning blame for a financial crisis
The report goes a step further by singling out four innovations that its authors believe directly contributed to the 2008/2009 global financial contagion. The first among these are so-called Mortgage Backed Securities (MBS), a financial innovation borne out of the US government’s need to “remove mortgage-related debt from the federal budget – [as well as] the desire to make mortgages more easily available to US households and the need to manage interest rate risk exposure.” These products led to the pooling of mortgage debt which was subsequently sold to investors with various risk / reward appetites. Banks and financial institutions with an appetite for risk ended up holding billions of dollars in sub-prime MBS!
The second financial innovation singled out for criticism is Collateralised Debt Obligations (CDOs). This product combined the cash flows from bundles of low credit quality corporate bonds, with defined payment schedules, into investment tranches of similar risk. CDOs did for bonds what MBS did for mortgages: they reduced risk by packaging bonds with similar profiles together and “selling” these packages. This solution was clearly too “tame” for financial institutions, because they soon developed synthetic CDOs. “These products were warmly welcomed as investor appetite for CDOs increased and threatened to overwhelm the available supply of seemingly-suitable mortgage assets,” notes the report.
The third and fourth “bad” innovation are Credit Default Swaps (CDSs), which allowed investment banks to swap the default risk on a particular line of credit in return for fees; and Structured Investment Vehicles (SIVs), which use the short-term commercial paper market to fund the purchase of longer-term securities such as MBS and CDOs. Even the most basic assessment of these so-called innovations reveals a house of cards, with financial products created out of thin air, and already dodgy products reappearing in new and more complicated forms!
A cautious approach to future innovation
What should banks, insurers, re-insurers and regulators do to avoid a repeat of the 2008/2009 financial crisis? The report has a number of ideas, many of which are already being implemented by industry stakeholders worldwide. Among the report proposals is that stakeholders evaluate how risks are counted, measured and managed within the respective organization. Many of these requirements are ensconced in the Solvency Assessment and Management (SAM), applicable to local banks and insurers.
The second suggestion involves new product development and approval. It is proposed that innovators make a careful step-by-step reassessment of existing processes to be sure that innovation-specific dimensions are addressed. A third requirement is a reassessment and redesign of valuation, risk assessment and timing in calculating and paying compensation related to innovation. And finally, the report urges companies “to recommit to consumer-friendly principles of product and business process design to steer innovation in a direction that will regain customer trust and create a better alignment of interests between the bank or insurer and its customers”.
Regulators were called upon to build a pro-competitive marketplace, strengthen systemic risk oversight and monitoring and oversee the industry. Both the South African Financial Services Board (FSB) and National Treasury have taken numerous steps to achieve these outcomes. This is the reason interventions such as SAM and Treating Customers Fairly are only the first steps in an ongoing regulatory process.
Editor’s thoughts: Among National Treasury’s responses to the financial crisis was the publication of a “red book” titled A Safer Financial Sector to serve South Africa Better. The book proposes a two-prong approach to financial market regulation, with prudential regulation under the Reserve Bank and market conduct under the FSB. Do you think the regulators, banks and insurers are doing enough to avert future financial hiccups in South Africa? Add your comment below, or send it to [email protected]
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