How to promote innovation in financialservices industry?Presentation at the Valiko’s 25-years jubileum 4.10.2012Professor Olli-Pekka RuuskanenInsurance ScienceSchool of ManagementUniversity of Tampere
Olli-Pekka RuuskanenContent1. Introduction2. Innovation in financial services3. New challenges4. Regulation and innovation5. Conclusion
Olli-Pekka RuuskanenSituation today• Customers demand more choices, increased transparency in rates and greater convenience.• Governments demand more transparency and more adherence to risks• Competitors are emerging with new business models and non-traditional delivery methods (Peverelli and De Feniks 2010)
Olli-Pekka RuuskanenFuture trends• Demographics• Big data and telematics• Social computing• Mobile web• Scalability in cloud• Polarization: Cheapest versus convenience• Regulation• Globalization
Olli-Pekka Ruuskanen89% of insurance CEOs indicate thattheir organization will need to implementsubstantial change. IBM Global CEO Survey, 2010
Olli-Pekka RuuskanenFunctions delivered by financial systems1. Moving funds across time and space2. Pooling of funds3. Managing risk4. Extracting information5. Addressing moral hazard and asymmetric information6. Facilitating sale through payment system. Merton (1992)
Olli-Pekka Ruuskanen”Finance is technology”, Robert Schiller
Olli-Pekka RuuskanenDefinition• ”Financial innovation is the act of creating and popularizing new financial instruments, technologies, institutions and markets.” Peter Tufano, Harvard Business School
Olli-Pekka RuuskanenWhat innovation does in finance (1)1. Innovations exist to complete incomplete markets2. Innovation persists to address inherent agency concerns and information asymmetries3. Innovation exists so parties can minimize transaction, search or marketing costs
Olli-Pekka RuuskanenWhat innovation does in finance (2)4. Innovation is a response to taxes and regulation5. Increasing globalization and risk motivate innovation6. Technological shocks stimulate innovation
Olli-Pekka RuuskanenINNOVATION = IDEA + COMMERCIALIZATION
Olli-Pekka Ruuskanen” In the past 25 years the only usefulinnovation in finance has been ATM.” Paul Volcker, Former Chairman of Federal Reserve, 2009
Olli-Pekka RuuskanenWhat makes innovation difficult infinance?• Conservativism• Protecting intellectual property difficult• Finland is a small market, can’t recoup investments• Risk avoidance• Regulation hinders innovation• The shadow of the 2007/2008 financial crises
Olli-Pekka RuuskanenWhat makes innovation difficult infinance? (… continued)• Maturity of the market• Limits to insurability• Lack of demand / financial literacy• Data limitations• Ambiguity of risks• Asymmetric information• Basis risk
Olli-Pekka RuuskanenEvidence from national surveys oninnovation• Importance – How many firms active• Intensity – Expenditure on R & D• Ingenuity – New to firm / new to market
Olli-Pekka RuuskanenCase: Insurance and Financial Services• Variation in reported innovation activities across countries• Innovation in financial intermeditation large• 80 % German insurers claim innovative products• The share of turnover from new products lower in financial services• Skewed towards smaller countries
Olli-Pekka RuuskanenHow difficult to copy innovations?
Olli-Pekka RuuskanenExamples of innovation in banking andinsurance
Olli-Pekka RuuskanenExamples• Mutual funds• Exchange traded funds• Catastrophy/mortality bonds• Alternative Risk Transfer• Algorithmic trading• Insurance futures• Industry loss warranties
Olli-Pekka RuuskanenMajor innovations in insurance
Olli-Pekka RuuskanenFinance is a Service• Banking• Insurance• Knowledge engineering
Olli-Pekka RuuskanenService industries are about solvingconsumer problems• What fundamental problem is the customer trying to solve?• What objectives do customers use to evaluate solutions?• What barriers limit the solution?• What solutions do customers consider?• What opportunities exist for innovative solutions?
Olli-Pekka RuuskanenIncremental innovation in insurance• Policy amandments• Bundling and unbundling• Parametric insurance
Olli-Pekka Ruuskanen Mutation in innovation• Innovation often intentionally span across different labels.• Financial innovation spiral (Person & Warther 1997) • ”Adoption provides other participants with information about the profitability of innovation, creating waves of innovation and S-curve”• Security created -> slightly modified by competitors• 1980 – 2001 1,836 security codes in Thomson- Reuters database.
Olli-Pekka RuuskanenIn finance counterparty matters• B 2 C• B 2 B• B 2 W• I 2 R
Olli-Pekka RuuskanenBack office problems• Infrastructure lacks when innovation takes off • Trade confirmation • Settlements • Contractual verification and standardization • Risk aggregation • Collateral determination
Olli-Pekka RuuskanenMotivation for innovation?”There are things we know, that we know.There are things we know, that we don’t know.and then there are those things that we don’t knowthat we don’t know.” Colin Powell, 1991
Olli-Pekka RuuskanenUnstructured versus structured data• Banking and insurance have used structured data• The challenge of unstructured data• Legacy systems• Real time underwriting• Real time credit• Semantic web
Olli-Pekka RuuskanenReal time, ubiqious, personal data• RFID technologies• GPS• GIS• Digital imagery• Health informatics• Genetics• Privacy?
Olli-Pekka RuuskanenPatents in Financial Services• Business method patents• State Street v Signature Financial, 1998.• U.S. Patent Office• 2010 reduction in scope ”Bilski vs Kappos”- ruling• Failure of finance patents to give proper attribution to prior art• Few patent litigation cases in U.S. finance• European Patent Authority
Olli-Pekka RuuskanenMicrofinance and microinsurance• Microfinance is typically a small loan given to low-income people without collateral guaranteed by a group.• Microinsurance is protection of low-income people against specific perils in exchange for regular premium payments proportionate to the likelihood and cost of the risk involved.• Cost efficency is key.
Olli-Pekka RuuskanenMy personal favorites• Proactive transparency• User assigned reputation scores• Consumer based buying clubs• User based underwriting and risk assessment• Telematics• Claims tracking systems• Mass customization• Supporting data disclosure or low-risk demonstration
Olli-Pekka RuuskanenRegulation”Finance is at its most dangerous when it isperceived to be safe.” Andrew Palmer, The Economist
Olli-Pekka RuuskanenFrameworks for innovation• Basel III• Solvency II Is there room for innovation?
Olli-Pekka RuuskanenRegulation and Innovation (1)(Lumpkin 2008) 1. Adopt an unbiased stance. 2. Ensure that necessary framework conditions for markets to function 3. Acknowledge that there is no one policy measure that can be considered optimal in all circumstances
Olli-Pekka RuuskanenRegulation and Innovation (2)(Lumpkin 2008) 4. Ensure that the policy instruments needed to achive incentive-compatible objectives are in the toolkit. • Clarify what is meant by maintaining systemic stability • Properly address exit problems for large institutions • Establish a proper macro-prudential framework • Establish a proper consumer protection framework
Olli-Pekka RuuskanenRegulation and Innovation (3)(Lumpkin 2008) 5. Ensure regulators and supervisors have the requisite skills and expertise 6. Ensure a proper balance between regulation and governance 7. There should be appropriate monitoring of a new products, markets and processes 8. Adopt the regulatory system as a necessary to the market environment it is intended to regulate
Olli-Pekka RuuskanenTipping point• Finance lacks ”off” button• When does a new innovation become systemically significant?• When will the flaws in innovation start having far reaching consequences?
Olli-Pekka RuuskanenRegulatory evaluation of financialinnovations• Target of innovation• Core purpose of innovation• True value added or transfer between participants• Key assumptions underlying innovation• Timing of innovation• Revolutionary or adaptive• Change in institutional structure or business models.
Olli-Pekka Ruuskanen”Some radical innovation may ultimately beneeded to deliver sustainably higher growth” Darren Pain, Swiss Re
Olli-Pekka RuuskanenConclusions• Financial services industry needs more innovation and creativity in the future.• Technology and data are keys to disruptive innovation.• Paradigm shift: from conservative to innovative culture within organizations.• Regulation is a constraint. Should be possibility