Financial Innovation

Financial innovation is the creation of new financial instruments, products, services, institutions, or markets. The innovations and use of digital technologies improve economic opportunity and promote financial inclusion.

A wave of technology gives an efficient outlook to the financial service industry, making it secure and affordable. However, many more innovations are still not adopted or utilized by the financial sector. Furthermore, despite all the advancements in financial services, a large portion of the sector still has challenges implementing such advancements in its core business offering.

• Financial innovation is the development of new financial products, processes, services, institutions, or markets. Acceptance and integration of new technologies make the scope for the changes in the financial sector vast.
• Examples include cardless ATM services, weather derivatives, central bank digital currency, QR code payment, hedge funds, and exchange-traded funds.
• There are different types of financial innovations: product, process, and institutional.
• Digital innovation helps improve financial inclusion and increase financial literacy not only among the banked population but also among the unbanked population.

Financial innovation improves institutions' ability to sustain themselves and reach out to the underprivileged. As a result, the development of financial markets and the IT sector are closely interconnected. Specifically, they share a positive correlation.

There are two distinct eras in the financial sector's recent history. The first, from the 1940s to the 1970s, is characterized by strong control, interventionism, and stability. The second phase, which started in the 1970s and continued until the subprime mortgage crisis started in 2007, was a period of deregulation and increasing volatility. As witnessed during the crises in the United States and Japan, the heightened instability in the second period has its roots in this liberalization coupled with a completely inadequate regulatory structure. In addition, multiple innovations in payment methods such as credit and debit cards, transaction processing machines: ATMs, telephone and online banking, automated credit scoring, and risk management strategies were introduced during the second period-derivatives and securitization.

There are different types of financial innovations discussed below: 

• Process Innovations: Innovative financial business processes give clients better services and boost the effectiveness of business operations. These innovations include new company procedures that boost productivity and open up new markets, among others. The simplest example is the online banking facility.

• Financial Institutional Innovations: The advancement of the financial system, which is a prerequisite for economic growth, depends on innovation. Examples include the establishment of a new organization providing innovative practices or services. However, creating a regulatory framework that promotes innovation, globalization, and the growth of the financial sector while maintaining a fair balance between private and social incentives is challenging.  

• Product Innovations: It introduces financial innovation products or instruments such as weather derivatives and family wealth accounts. Product innovations are released to better adapt to the changing consumer demand or to increase efficiency.

There are various causes of financial innovations, such as: 

• Technological advancements and payment system innovations.
• Competition
• Financial globalization
• Market failures, financial insecurity, domino effects, potentially high systemic risks, etc., trigger the need for innovation initiatives.

Many traditional banks are reinventing their business models to incorporate diverse digital channels, digitized financial services, and digital communications opportunities. The main purpose is to provide better service to customers and compete with venture-backed disruptors. It is challenging to accomplish, though, as most traditional banks follow the brick-and-mortar model and hold the disadvantage of having infrastructure not fit for the modern world.

Let us look at the financial innovation examples to understand the concept better: 

Example #1

One of the biggest financial innovation examples in the world is PayPal. In addition to adding more partners, PayPal is also aiming at aging financial infrastructures due to its significant market share, making it a popular option for businesses looking to expand their online and contactless payment options. However, throughout COVID-19, PayPal has shown that it is a rapidly advancing fintech, providing several options like buy now, pay later (BNPL) financing and PPP money distribution, which place the company as a formidable rival to conventional banks.

Example #2

M-Pesa has evolved to be the biggest payment system in Africa. The banked and unbanked people of Kenya, who reside in rural regions, can deposit, transfer, and withdraw money and use their mobile phones to make purchases thanks to this platform. In addition, users can store money in an account that can be accessed via text message with a PIN using this branchless banking service.

The advantages and disadvantages of financial innovation are as follows. 

Advantages

• Financial intermediaries benefit from economies of scale by bundling related financial services that can be delivered to the customers preferring a conveniently offered suite of products. 

• The Internet and mobile technology have drastically increased the ability to inform and interact remotely between businesses and directly with customers. In addition, technology has increased access and the efficiency of direct delivery channels, offering lower-cost, tailored financial services and improving financial inclusion.

• Digital innovation reduces transaction costs and enables various innovative financial services and business models. The adoption of new technological advancements influences both traditional and emerging providers. Digital technologies can assist in lowering the costs of information collection, storage, processing, and exchange.

Disadvantages

• Fintech companies have de facto control over sensitive information. Users must be given more autonomy and control over their data.

• Fintech and big tech face cybersecurity challenges. Moreover, the attacks spread as interconnectivity expands and service disaggregation adds more links.

• The fixed-cost infrastructure of the technology does not reduce at the same rate as technology becomes obsolete. In addition, there are regulatory frameworks that are impeding the entry of new market participants.

This article has been a guide to What is Financial Innovation and its meaning. Here, we explain its types, causes, examples, advantages & disadvantages. You can learn more about it from the following articles -

• Financial Management
• Financial Engineering
• NBFC