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Page last updated
February 16, 2003

 

 

ISix Pillars of Financial Innovation

Six people seated around the walls of a darkened room. In the open middle space is a chair. Who finds it? Those that sat still and philosophised about where chairs are usually placed in rooms? The innovator who would locate it is the one who'd get up, walk and stumble until he discovered it. Nobody ever found anything whilst sitting down. So QED don't be afraid to stumble. - Charles Kettering

Ease of entry
In the financial market the barriers to product development are incredibly low. Unlike in the industrial world, a manufacturer of a financial product such as a fixed rate mortgage or an inflation-linked deposit product does not have to create the product and stock shelves. Even in the retail financial services, with the product offered at a fixed rate, the bank always has the right to withdraw the offer. There is usually a "Special Limited Offer" splashed on prominently. The costs of producing a retail product are limited to the costs of stationary, staff training and computer systems.

In the wholesale financial markets, the costs of developing products are even lower. One of the most successful product launches was that of a currency option based structure. The object of the product was to lower the costs for corporations wanting to tender for overseas contracts. Let us consider a group of UK firms bidding separately for a contract in the US. The theory was that they could buy one currency option to sell US Dollars and buy GB Pounds and split the costs of the option amongst themselves. This product was the Shared Currency Option Under Tender (SCOUT).

We drew up legal documentation, produced marketing literature and called the press. The product launch successfully generated widespread publicity but not a single SCOUT was sold! I don't believe that any client even asked for a quotation. But so what? Who knows to this day that the product was a complete flop in terms of business generated. But it increased awareness of the bank's capabilities in treasury products and led to standard options business.

Copyright
It is interesting to examine innovation in another industry - the software industry. In some ways the financial product business is quite similar to the software business. They are not capital intensive - they are both ideas intensive. If Apple or Netscape has a good idea for a way of doing something then until very recently the business process could not be successfully patented. The software code could be protected and the look and feel but the basic idea could not. Apple produced graphical user interfaces (GUIs) well before Microsoft's Windows, SuperCalc and Lotus 123 preceded Microsoft's Excel and Word Perfect had a dominant market share of word processing well before Microsoft launched Word. In software, the firm that wins is not necessarily the firm that innovates.

So it has been in the world of financial product innovation. In the late 1980s Spanish banks began to pay interest on cheque accounts. The competition was described in war-like terms: as "La Guerra de Super Cuentas". Banco Santander was generally credited with having started this 'super account war'. But it was Barclays Bank that introduced interest on current accounts into its relatively small operation in Spain.

Fixed rate mortgages cannot be patented.
It now appears that financial products can be patented in the US. The business process through which a firm develops, markets and manages a financial product defined by the business process can be patented. This will ensure that the ideas generated by product developers provided they can be fully formulated will be protected. I am in the process of patenting two financing schemes so I cannot yet vouch for the efficacy of this intellectual property protection process.

Six pillars of financial innovation

There are six main pillars of financial innovation:

1 Competitive Innovation

2 Regulatory Innovation

3 Accounting Innovation

4 Taxation Innovation

5 Religious Innovation

6 Ignorance Innovation.

Competitive Innovation
The largest institutions in any industry are often not the leaders in the early-stages of innovation. In the words of the slogan that never was: 'We're number one. Why try harder?' It is the second-placed firm that has to say 'We try harder' to paraphrase the Avis' slogan countering Hertz's "We're number One".

But in a free market with low-cost ease of access though the internet, unless firms can develop new financial instruments that meet the changing needs of the market place they will be by-passed. It is no good just being on the right track. If you just stand there you will be run over.

So competitive innovation seeks to provide a firm's clients with better solutions to its problems. Banks thereby hope to generate a higher market share or a higher profit through satisfying the customer's needs - the famously touted 'needs-driven approach'. A banks marketing director who religiously stuck to this approach and proudly stated that he never mentioned products to customers. At the end of the day a bank's marketing team has to provide their customers with a product or a service.

Of the six pillars of financial innovation competative Innovation is the most difficult and rarest. There is no free lunch here and margins are slim with such innovation. But unsurprisingly the other forms of financial innovation described below are dressed up for customer consumption to look like Competitive Innovation.

Regulatory Innovation
The Eurobond market was created in London by the London merchant bank, SG Warburg as a result of two main forces. Firstly, there were regulatory restrictions and fiscal impositions in the United States. Secondly, because of the cold war the USSR was not keen to invest its funds in the U.S. A relatively free Eurobond market was developed in London for borrowers and investors who wished to avoid US controls.

In 1978 there were very strict quantitative controls on bank lending in the UK. The growth in Interest bearing eligible liabilities (IBELs) was controlled with strict penalties imposed by the Bank of England on banks that exceeded permitted growth. Several regulatory arbitrage schemes were employed to maintain bank lending but avoid paying penalties. The bank loaned money through Bankers Acceptances which if sold on did not count as IBELs. Lending was also done through the bank's Paris branch. Such offshore lending even denominated in Sterling did not count for IBELs. And where possible lending was carried out between "make-up days", the dates on which the monthly balance sheets were drawn up for Bank of England reporting purposes. This was to such an extent that the bank's IBELs used to fall after the make-up days by as much as 30 per cent.

Regulatory Innovation could also include products such as credit derivatives and insurance derivatives. There is a grey area between insurance and banking and the treatment of similar instruments is quite different between them. It pays to be able to choose to book structures in either an insurance company or bank on a case by case basis.

A number of products have also been target specifically at fund managers with tight regulatory controls. Many such managers are not authorised to use derivatives. But they can buy investments with built in derivatives structures to provide them with the gearing and risk pattern they seek. Such products were designed specifically for some highly regulated investment funds. In some cases individual institutional investors have bought entire issues of highly geared bonds.

Accounting Innovation
The Break Forward was a case of both Accounting innovation and Taxation Innovation. Finance directors were reluctant to pay currency option premiums up-front. After all, they did not have to do so for standard forward exchange contracts. So developed the Break Forward out of a currency option with no explicit option premium. The premium was embedded in the packaged product which consisted of two contracts - a forward contract at a rate worse that market and a "free" option to unwind. The cash value of the difference between the two contracts amounted to the future value of the option premium. Corporate treasurers knew what they were doing and understood that they were buying options. This was fully explained to them. But the break forward structure was easier to explain to boards of directors who had been comfortable with Forwards. A case of Accounting Innovation.

Taxation Innovation
The two case studies on the Break Forward and The Perpetual Swap both were largely tax driven innovations. It is all very well coming up with solutions to customer problems but unless a third party (the tax man) is contributing to the pot, the profitability of deals is often insufficient to justify the effort.

Zero coupon bonds and deep discounted securities were initially tax driven products in addition to their portfolio immunisation benefits. In most jurisdictions, capital gains was generally until fairly recently taxed much more favourably, if taxed at all, than income. Interest was converted into capital gains by various methods. Such schemes are no longer tax efficient.

Taxation Innovation is on the wane as many jurisdictions now have the right to retrospectively tax what they deem to be tax avoidance schemes.

Religious Innovation
Religious Innovation here largely refers to Islamic banking. But there has been a great number of such financial instruments that has only paid lip-service to such objectives.

Islamic Banking is more than the prohibition of interest. In conventional banking terms, it is about the introduction of a no pain no gain system of banking or venture capital investment. But the vast majority of Islamic Banking schemes amount to converting interest into capital gains. The processes here were very similar to the tax minimisation schemes involving interest elimination. Fifteen years ago zero coupon bonds and treasury bills were acceptable. Whilst these instruments are no longer Islamically acceptable, other interest into capital gains structures leaving no risk to the investor are still acceptable.

Religious Innovation is not just limited to Islamic Banking. Many non-Islamic countries have usury laws to control maximum interest rates payable by consumers. And recently a number of ethical investment funds have been created to channel funds into firms not dealing with items such as tobacco , alcohol and armaments.

Ignorance Innovation
Competitive Innovation seeks to generate new customer solutions through a 'needs-driven' approach. But what is often not obvious is that the 'needs' referred to are those of the bank traders and directors' bonuses rather than those of their customers. Ignorance innovation is plain and simple 'ripping-off' customers not through any fraud or misrepresentation but through creative financial engineering. And the customer may be perfectly happy with the product and the excess profit engineered may well be opportunity profit. If the customer knew how to structure such deals for itself then it would have obtained a much better package price for the structure.

Sometimes the ignorance may apply not to the corporate treasurer doing the deal but to his superiors. Such innovation falls under Accounting innovation.

Some public cases where customers may have believed that they were victims of Ignorance innovation. Perpetual Floating Rate Notes were issued by banks in the mid 1980s. FRNs traditionally had maturities between 5 years and 15 years. Naturally, they did not count as primary capital in the same way as did retained earnings or shareholders'funds. So banks issued FRNs but with no maturity date. The structure was akin to preference shares but with floating rates. There was no obligation to repay the 'loans' at any time. The ability of an investor to realise his investment crucially depended on an active and liquid secondary market. And this was limited as banks that held other banks' Perpetual FRNs found that their capital base was reduced by regulators in line with their holdings of such "Perps". Gradually it dawned upon investors the true nature of these Perps. They had bought bank liability instruments that they believed were almost like deposits but paying 25 basis points over LIBOR. As investors stormed out of positions in the Perpetual FRNs, prices crashed within days to 80 per cent of the par value they had been trading. The yield was now a more reasonable but still low 250 basis points over LIBOR for bank equity. A case of what appeared to be Regulatory Innovation was really Ignorance Innovation

Conclusion
Of the six types of financial innovation it would be nice to think that genuine needs-driven Competitive Innovation was the most common. Regulatory Innovation will no doubt continue. Accounting Innovation will depend on performance management systems. It is much more easy to generate accounting profits than real profits and every competent financial engineer is capable of manipulating his management accounts. Religious Innovation which includes Ethical innovation is increasing as Western banks provide Islamic financial instruments and retail investors increasingly seek 'green' investments. Ignorance innovation will always be around but to a much lower degree. Corporations and retail investors are increasingly likely to cry foul and take banks to court. Even if there is a settlement out of court or the bank wins the case any whiff of sharp practice can seriously damage a bank's reputation.

Warren Edwardes

Warren Edwardes is CEO of Delphi Risk Management, the London-based financial product creativity, communication and control consultancy. He is founder of the b2b internet start-up school of banking.com at the London international school of banking and finance.

Warren was previously on the board of Charterhouse Bank and has worked in the treasury divisions of Barclays Bank, British Gas and Midland Bank. He first researched into what were later to be called "derivatives" in 1975 and was part of the team that executed one of the world's first currency swaps in 1981. Since then he has devised and transacted numerous structures that form part of the history of derivatives.

 


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