Why does financial innovation occur

Expert Assisted Services. Tax Saving. Mutual Fund Investments. GST Software. TaxCloud Direct Tax Software. Need Help? About us. Download link sent. Category Investing. Silicon Valley is coming.

There are hundreds of startups with a lot of brains and money working on various alternatives to traditional banking. The ones you read about most are in the lending business, whereby the firms can lend to individuals and small businesses very quickly and — these entities believe — effectively by using Big Data to enhance credit underwriting. We are going to work hard to make our services as seamless and competitive as theirs.

And we also are completely comfortable with partnering where it makes sense Dimon Startups play an important role in changing the process and landscape of innovation activities Spender et al. Innovators outside the conventional system, such as startups, may have more freedom in experimenting with new ideas and methods and, should they succeed in achieving an important discovery, players from the conventional system who have weak ties to the innovators outside the system may achieve better results Rogers, Mohan shows that there are emerging signs of collaboration between banks and Fintech startups.

Behavioral theory is the third motor of development in institutional theory. The emphasis on the importance of behavioral theory in the study of financial innovation has been increasing since the financial crisis of Shiller, The behavioral model explains the interaction between financial innovation and the behaviors of participants in financial markets. Integrating elements from behavioral theory into financial innovations can have positive consequences for the management and design of new financial innovations Shefrin and Statman, and financial regulation Shiller, On the one hand, behavioral aspects could be perceived as a precondition for the emergence and diffusion of financial innovations.

For example, Bhatt suggests that trust is among the essential factors that contribute to the development of financial innovations since no financial innovation is possible without a general climate of confidence.

This is important because end-users of financial products and services can sometimes lack the knowledge and capabilities necessary to evaluate financial innovations and related information accurately. Therefore, there is a need for some form of assurance. Additionally, Salampasis et al.

On the other hand, financial innovations can induce certain behaviors in their adopters with positive or negative consequences. For example, a field study showed that farmers who faced uncertain weather conditions changed their behavior after the adoption of new risk management products.

The adoption of the new financial innovation induced farmers to invest more in higher sensitivity cash crops Cole et al. Santomero and Trester show that financial innovation can induce banks to increase their risk profile.

Shiller a discussed the development of private accounts for social security driven by behavioral roots. According to Stiglitz , institutional changes that took place in the period before the crisis induced markets to develop financial innovations and strategies that were short-sighted.

With the shift to short-termism, the natural selection laws ceased to be the driving force of market innovation. The last theory in the institutional model is regulation. Regulation can interact with the process of financial innovation in two ways. First, regulation can be a driver of financial innovation. For example, a new regulation can forbid banks or other institutions to engage in a certain financial activity.

To circumvent these regulations, banks can innovate to maintain their profits. Other forms of regulation-driven financial innovations are focused on avoiding capital requirements such as securitization. On the other hand, financial regulation can be reinforced to actively encourage market participants to develop beneficial and responsible financial innovations. Following the crisis, increasing attention has been paid to the role of regulation in designing mechanisms for responsible and social financial innovations.

Thus, regulation remains a crucial driver of the development and direction of financial innovations. Institutional theory holds when institutional changes and the structure of market interaction is the driving force of financial innovation development.

No assumption concerning the historical development course or economic factors is assumed in institutional theory. Institutional theory results are useful when cross-regional differences in financial innovation are observed. An outstanding example of how institutional factors can lead to the emergence of financial innovations is money market funds Wall, In and , banking acts were passed in the United States that gave the Federal Reserve the freedom to ceil interest rates paid by commercial banks on savings and time deposits.

This regulation is famously known as Regulation Q. This regulation created an institutional barrier for investors mostly small investors who sought interest payment on their deposits. To overcome this regulatory constraint, Bruce R. Bent and Henry B. Brown created an alternative in called a money market fund. The fund was named the Reserve Fund, and it offered services to investors who wanted to secure a modest rate of return on their cash and earnings.

Money market funds invested in low-risk securities that paid interest rates in line with market rates, such as certificates of deposit. As Regulation Q ceilings continued to fall behind market rates in the late s, investments in money market funds grew rapidly, and many more funds were created Fink, The previous section discussed the theories of development of financial innovations and the contingencies under which each development theory applies.

However, observed financial innovation processes may be more complex than any of these theories suggest because the development of an innovation can be triggered by an interplay among the theories Poole et al. Therefore, we posit that a good meta-theory of financial innovation must allow for inter-level combinations of the four theories to better account for the complexity of financial innovation processes. This section provides some examples of how the different models can be combined to explain the development of financial innovations under different conditions.

The following examples should encourage researchers to develop more detailed and complex models to better understand the process of financial innovation. In some cases, the life-cycle model can be extended to include institutional requirements instead of logical laws. For example, some financial innovations occur only after many law-making and regulation stages, in which case the regulation theory under the institutional theory can be adopted to better explain the financial innovation at hand.

An example of this could be the period between the introduction of the Glass Steagall and Gramm Leach Bliley Acts and the engagement of US commercial banks in securities markets and the introduction of financial innovations Walter, Additionally, although the life-cycle theory argues in favor of financial innovation being a continuous sequence of events, discontinuities could exist, and economic theory could help explain this inconsistency by assuming demand and supply factors Philippas and Siriopoulos, Finally, related to the life-cycle theory, evolutionary theory can be adopted to explain the logic where several enabling technologies in the space of possibilities can be assumed necessary for the next stage in the life-cycle of financial innovations Loreto et al.

In many cases, the development of financial innovations may be technologically feasible. Consideration of institutional aspects or institutional changes might be necessary before they can emerge.

For example, in analyzing the idea of radical financial innovations in macro risk management, Shiller, b argues that such financial innovations would be possible only if combining existing information technology with institutional aspects like behavioral finance is considered. The self-organization idea is associated with the life-cycle theory to explain the development of important financial innovations like stock exchanges, clearing houses, and fractional reserve banking, each of which has a long history and has emerged without direct government control see, for example, Campbell-Kelly, This paper proposes a new theoretical approach to the study of the financial innovation process using a meta-theoretic method.

The need for such a theory is justified by the increasing complexity and diversity of financial innovations, which makes it impossible to construct a single general theory for financial innovation. By relying on the research method proposed by Poole and Van de Ven , four ideal-type theories of financial innovation development are identified: life-cycle theory, evolutionary theory, economic theory, and institutional theory.

Each of these theories has rich scientific traditions, and they offer different interpretations of the financial innovation process.

The main advantage of the proposed meta-theory is that it makes it possible to construct contextualized explanatory models of different financial innovations without assuming any restrictive assumptions. The development of financial innovations can be more complex than any of the proposed four theories suggest, and the reason is the inter-level connections between the different development theories. The proposed meta-theoretic approach allows for combining different parts of each theory to construct more realistic and dynamic theories for financial innovation.

However, more research is needed to validate and extend the proposed framework. An extension could be to explore the inter-level relationships between the proposed theories, the criteria to be used when switching between models, and the weight to be assigned to each model in explaining a financial innovation. To some extent, this might seem reductionist and not a reflection of the likelihood of feedback loops or interdependencies among the proposed models.

Another extension that might be useful is to consider the role of complexity theory in the development of financial innovations. Concepts including non-linear dynamics, emergent phenomena, and networks deserve more investigation as potential explanatory models of financial innovation.

The proposed meta-theoretic framework is an innovative tool for academics and researchers that can be used to better understand and communicate financial innovation theory. Additionally, it can help managers and decision makers improve their decisions where financial innovation is concerned. The dynamic nature of financial markets, the increasing competition from Fintech startups, regulation, and the increasing complexity of consumer demand are factors that increase the need to communicate to managers how financial innovation occurs in a firm and the factors affecting its successful development.

Akamavi RK A research agenda for investigation of product innovation in the financial services sector. J Serv Mark 19 6 — Article Google Scholar.

Akhavein J, Frame WS, White LJ The diffusion of financial innovations: an examination of the adoption of small business credit scoring by large banking organizations. J Bus 78 2 — Allen F Presidential address: do financial institutions matter? J Financ 56 4 — Allen F, Babus A Networks in finance.

Pearson Prentice Hall, pp — Allen F, Gale D Financial innovation and risk sharing. MIT Press, Cambridge. Google Scholar. Al-Sharieh S, Mention A Open innovation and intellectual property: the relationship and its challenges.

In: Ran B ed Contemporary perspectives on technological innovation, management and policy: dark side of technological innovation. Information age publishing, Charlotte, pp — Edward Elgar Publishing. J Financial Regulation and Compliance 20 2 — In ICS pp. Arrow K Economic welfare and the allocation of resources for invention. In: The rate and direction of inventive activity: economic and social factors.

Princeton University press, pp — Arthur K Financial innovation and its governance: cases of two major innovations in the financial sector. Financial Innovation Arthur WB The nature of technology: what it is and how it evolves. Simon and Schuster. Asante K, Owen R, Williamson G Governance of new product development and perceptions of responsible innovation in the financial sector: insights from an ethnographic case study.

J Responsib Innov 1 1 :9— Awrey D Complexity, innovation and the regulation of modern financial markets. Harvard Business Law Review 2 2 Awrey D Toward a supply-side theory of financial innovation. J Comp Econ 41 2 — Barlow D The evolution of risk management.

Risk Manag 40 4 Int J Fin Serv Manag 1 4 — Baumol WJ The free-market innovation machine: analyzing the growth miracle of capitalism. Princeton university press. Beard C, Dougan S Winning new product development strategies in financial services. Business Insights, Management Report, pp 8— J Bank Financ — J Bank Financ 1 3 — Bernanke BS Modern risk management and banking supervision No.

Rev Econ Stud 68 3 — Bhatt VV Financial innovations and credit market evolution. Econ Polit Wkly— Bhattacharyya S, Nanda V Client discretion, switching costs, and financial innovation. Rev Financ Stud 13 4 — In: Bhole LM ed Financial institutions and markets: structure, growth and innovations, 4e. Tata McGraw-hill education, pp 3— A comparison between product, process and organizational innovation.

Int J Technol Manag 22 1—3 — Rev Financ Stud 10 4 — J Monet Econ — Campbell-Kelly M Victorian data processing. Commun ACM 53 10 — Cavanna H Financial innovation. J Evol Econ 24 5 — The review of Economics and Statistics, pp— Evidence from a field experiment, Review of Financial Studies.

Collingridge D The social control of technology. Frances Printer Publishers Ltd, London. Crotty J If financial market competition is intense, why are financial firm profits so high? Damanpour F Organizational innovation: a meta-analysis of effects of determinants and moderators.

Acad Manag J 34 3 — Davis LE The evolution of the American capital market a case study in institutional change. Int J Entrep Innov Manag 16 1—2 — Dosi G Technological paradigms and technological trajectories: a suggested interpretation of the determinants and directions of technical change. Res Policy 11 3 — Drew SA Accelerating innovation in financial services. Long Range Planning 28 4 :1— Duffie D, Rahi R Financial market innovation and security design: an introduction.

J Econ Theory 65 1 :1— J Monet Econ 53 1 — Econ Soc 39 1 — Res Policy 45 3 — Field P Modern risk management: a history. Fink MP The rise of mutual funds: an insider's view. Book Google Scholar. Finnerty JD Debt Management. Harvard Business School Press. Flood MD Two faces of financial innovation. Review J Econ Lit 42 1 — Oxford university press, pp.

MIT press. J Financ Econ 3 — Goetzmann WN, Rouwenhorst KG The origins of value: the financial innovations that created modern capital markets. Oxford University Press. Manchester School 70 March — Granovetter MS The strength of weak ties. Am J Sociol 78 6 — Greenwood R, Scharfstein D The growth of finance. J Econ Perspect 27 2 :3— Guill GD Bankers trust and the birth of modern risk management. J Appl Corp Financ 28 1 — Haldane AG Rethinking the financial network.

Haliassos M Financial innovation: too much or too little? MIT Press. Butler Books, Canada. Harris M, Raviv A The design of securities.

J Financ Econ 24 2 — Hausman A, Johnston WJ The role of innovation in driving the economy: lessons from the global financial crisis. J Bus Res 67 1 — Helpman E Innovation, imitation, and intellectual property rights. Econometrica — J Financ 66 1 :1— Henderson BJ, Pearson ND The dark side of financial innovation: a case study of the pricing of a retail financial product. J Financ Econ 2 — Herrera H, Schroth EJ Developer's expertise and the dynamics of financial innovation: theory and evidence.

Holland JH Complexity: a very short introduction. Horne JC Of financial innovations and excesses. J Financ 40 3 — Hu H New financial products, the modern process of financial innovation, and the puzzle of shareholder welfare. Texas Law Review Contemp Econ Policy 28 3 — Ilyina A, Samaniego R Technology and financial development. J Money Credit Bank 43 5 — Ingham H, Thompson S The adoption of new technology in financial services: the case of building societies.

Econ Innov New Technol 2 4 — Iwamura A, Jog VM Innovators, organization structure and management of the innovation process in the securities industry. J Prod Innov Manag 8 2 — Eur J Innov Manag 4 1 — Rev Financ Stud 2 1 :1— J Econ Behav Organ 43 2 — Kauffman SA The sciences of complexity and" origins of order". In PSA: proceedings of the biennial meeting of the philosophy of science association Vol. Keith S Measuring innovation, in Fagerberg, J. Kiernan K From ancient Greece to wall street: a brief history of the options market.

J Econ Perspect 27 2 — Camb J Econ 28 5 — Lerner J The new new financial thing: the origins of financial innovations. J Financ Econ 79 2 — Lerner J The litigation of financial innovations. J Law Econ 53 4 — Lerner J, Tufano P The consequences of financial innovation: a counterfactual research agenda. Annu Rev Financ Econ 3 1 — Levine R Financial development and economic growth: views and agenda. J Econ Lit 35 2 — Llewellyn DT Financial innovation: a basic analysis. Cavanna Ed. Springer International Publishing, pp 59— Basic books.

Prentice Hall. Mention AL, Torkkeli M Drivers, processes and consequences of financial innovation: a research agenda. Int J Entrep Innov Manag 16 1—2 :5— Cambridge Scholars Publishing. Merton RC Financial innovation and economic performance. Journal of applied corporate finance 4 4 — Merton RC a A functional perspective of financial intermediation. Financ Manag— Merton RC b Influence of mathematical models in finance on practice: past, present, and future.

Mathematical models in. Miller MH Financial innovation: the last twenty years and the next. J Financ Quant Anal 21 04 — Mishra PK Financial innovation in emerging markets - possible benefits and risks, social science research network working paper series Mohan D How banks and FinTech startups are partnering for faster innovation.

Journal of digital. Banerjee, P. Financial advisers: what exactly do they do? Barras J Towards a theory of innovation in services. Res Policy — Int J Financ Serv Manag — Bessant J, Tidd J Innovation and entrepreneurship. Wiley, London. Blazevic V, Lievens A Managing innovation through customer coproduced knowledge in electronic services: an exploratory study. J Acad Market Sci — Bank of England, UK. Cox D Financial services regulation and corporate governance.

Wiley, New Jersey. CPA J — Chesbrough HW Open innovation: the new imperative for creating and profiting from technology. Collingridge D The social control of technology. Frances Printer Publishers Ltd, London. J Derivatives — Curran K, King D Investigating the human computer interaction problems with automated teller machine navigation menus.

Interactive Technol Smart Educ — Delimatsis, P. Financial Innovation and Transparency in Turbulent Times. SSRN eLibrary. European Central Bank. Monetary Financial Institutions [Online].

Financial Crisis Inquiry Commission The CDO Machine. In: Angelides, P. Financial Crisis Inquiry Report. J Econ Literature — Germain R Financial governance in historical perspective: lessons from the s. Cambridge University press, New York. Goode M, Moutinho L The effects of free banking on overall satisfaction: the use of automated teller machines.

Int J Bank Mark — Am Econ Rev — Gubler ZJ The financial innovation process: theory and application. Delaware J Corporate Law — Guerette, R. T and Clarke, R. Security Journal, 7— Harrington, S. Butler Books, Canada. Manag Decision — Lerner J, Tufano P The consequences of financial innovation : a counterfactual research agenda. Book Google Scholar. Llewellyn D Financial innovation: a basic analysis. In: Cavanna H ed Financial innovation. Routledge, London. Lucas, D.

Collateralized Debt Obligations: Structures and Analysis. Handbook of Finance. Mandell L The credit card industry: a history. J Struct Financ — Mishra, P. Mullard M The credit rating agencies and their contribution to the financial crisis. The Political Quarterly — Muniesa F, Lenglet M Responsible innovation in finance: directions and implications. Ind Corp Chang — Nightingale P, Poll R Innovation in investment banking: the dynamics of control systems within the Chandlerian firm.

Wiley, United Kingdom. Chapter Google Scholar. Pacces AM Consequences of uncertainty for regulation: law and economics of the financial crisis.

A typology of methods for customer co-creation in the innovation process. In: Wittke V, Hanekop H eds New forms of collaborative innovation and production on the internet: an interdisciplinary perspective. Pol, E. On regulating financial innovations. Pradier, P. Administering systemic risk vs. Accounting, Economics and Law A Convivium, 1, article Financial Innovation and the Global Crisis.

Stefanadis C Self-regulation, innovation, and the financial industry. J Regul Econ — Stefani, F. Stout, L. Tidd J, Bessant JR Managing innovation : integrating technological, market and organizational change. Wiley, Chichester. Tufano P Financial Innovation. Volcker P Paul Volcker: think more boldly. Future of Finance, Wall Street Journal. White LJ Technological change, financial innovation and financial regulation in the U. Cambridge U. Press, NY. Download references. The author thanks Prof.

Richard Owen for his invaluable guidance, supervision and proof-reading support. Further, much appreciation goes to her husband Albert Kwame Arthur and her son Nyameye Woodruff Arthur for their cooperation and encouragement.

Her research interests are in the area of Entrepreneurship and Innovation. She declares that she has no competing interests. You can also search for this author in PubMed Google Scholar. Correspondence to Keren Naa Abeka Arthur. Reprints and Permissions.