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Rethinking Financial Innovation Reducing Negative Outcomes While Retaining the Benefits

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Rethinking Financial Innovation Reducing Negative Outcomes While Retaining The Benefits A World Economic Forum report in collaboration with Oliver Wyman The information in this report, or upon which this report is based, has been obtained from sources the authors believe to be reliable and accurate. However, it has not been independently verified and no representation or warranty, express or implied, is made as to the accuracy or completeness of any information contained in this report obtained from third parties. Readers are cautioned not to place undue reliance on these statements. The World Economic Forum and its project advisers, Oliver Wyman and Clifford Chance LLP, undertake no obligation to publicly revise or update any statements, whether as a result of new information, future events or otherwise, and they shall in no event be liable for any loss or damage arising in connection with the use of the information in this report. The views expressed in this publication have been based on workshops, interviews and research, and do not necessarily reflect those of the World Economic Forum. World Economic Forum 91-93 route de la Capite CH-1223 Cologny/Geneva Tel.: +41 (0)22 869 1212 Fax: +41 (0)22 786 2744 E-mail: [email protected] www.weforum.org © 2012 World Economic Forum All rights reserved. No part of this publication may be reproduced or transmitted in any form or by any means, including photocopying and recording, or by any information storage and retrieval system. Contents 1 Contents 60 Part III: What experts have to say 2 Tables 61 8. Kirsten Apple: Business Method Patents: Debunking 3 Preface Three Myths 4 Steering committee members 63 9. Thomas Deinet: The investment sector and capital markets are the best breeding ground for financial innovation 4 Working group members 64 10. Daniel Hofmann: A Systemic Perspective on Innovation 4 Additional external contributors in Insurance 4 Project team 65 11. Josh Lerner: How Might Patenting Trends Reshape 4 Disclaimer Financial Services? 5 Letter from the Steering Committee 66 12. Alexander Ljungqvist: Disruptive Innovation: Are Stock 6 Executive summary Exchanges Under Threat? 9 Introduction – The project journey 67 13. Margaret Miller: Financial Literacy and Capability and 10 Part I: Recognizing and appreciating financial innovation Financial Innovation 11 1. The Importance of Innovation 69 14. Bill Shew: Innovation in Pharma and Lessons for Financial Services 12 1.1 What is innovation? 71 15. Piyush Tantia: Behavioural Economics and Consumer 13 1.2 Degrees of innovation Protection 14 1.3 The role of innovation in the economy 72 16. Jennifer Tescher: Self- Regulation and Consumer Trust 16 2. Focusing on Financial Innovation 73 17. Peter Tufano: Leveraging Financial Innovation to Serve 16 2.1 Defining financial innovation and its benefits the Poor 16 2.2 Benefits of financial innovation 74 18. Tim Wyles: The Agency Problem in Consumer Financial 20 2.3 Understanding the particular qualities of financial Services innovation 76 Appendix 24 3. The Role of Financial Innovations in the Financial Crisis 76 1. Historical Background to Selected Financial Innovations 24 3.1 Introduction 76 1.1 MBS 26 3.2 Mortgage Backed Securities (MBS) 76 1.2 CDOs 27 3.3 Collateralized Debt Obligations (CDOs) 78 2. The FSB Principles for Sound Compensation Practices 29 3.4 Credit Default Swaps (CDSs) 80 Acknowledgements 31 3.5 Structured Investment Vehicles (SIVs) 82 References 32 4. The Continuing Importance of Financial Innovation 86 Endnotes 32 4.1 Financial innovation in the post-crisis world: re-opening Pandora’s Box? 33 4.2 Where financial innovation creates value – four key opportunities for the future 37 5. Conclusion 38 Part II: Reducing negative outcomes 39 6. Structuring a Solution 39 6.1 The negative outcomes to be avoided 41 6.2 The innovation process disentangled 42 6.3 Innovation process – three discrete stages 43 6.4 Stakeholder groups 44 7. Recommendations 45 7.1 Review and adapt your Enterprise Risk Management (ERM) framework to address the incremental risks and uncertainties introduced by financial innovation 50 7.2 Revisit New Product Approval (NPA) processes to properly address the idiosyncrasies of financial innovation 52 7.3 Redesign incentives to provide the right motivation 54 7.4 Recommit and refocus innovation efforts to be customer oriented 57 7.5 Acknowledge the importance of innovation and its role in a competitive, free-market structure (and thus in pro-competition regulation) 58 7.6 Strengthen systemic risk oversight in light of the incremental risks and uncertainties introduced by financial innovation 59 7.7 Collaborate with the industry to monitor and oversee its efforts in managing innovation risks to drive sustainable financial innovation Rethinking Financial Innovation 1 Table of Tables Table of Quotes 16 Table 1: Functions of Financial Innovation Defined by Merton1995 14 Quote 1: Josh Lerner, Jacob H. Schiff Professor of Investment 17 Table 2: Examples of Financial Innovation over the Centuries Banking, Harvard Business School 18 Table 3: Functions of Financial Innovation Defined by Tufano 2003 14 Quote 2: Bill Shew, Partner, Oliver Wyman 19 Table 4: Examples of Financial Innovations and Their Benefits 15 Quote 3: Josh Lerner, Jacob H. Schiff Professor of Investment Banking, Harvard Business School 62 Table 5: Top Financial Services Firms and Business Methods Patents 15 Quote 4: Kirsten Apple, Primary Examiner 3694 on special assignment in the Office of Chief Economist, USPTO 16 Quote 5: Kirsten Apple, Primary Examiner 3694 on special Table of Callouts assignment in the Office of Chief Economist, USPTO 9 Callout 1: Project Objective 18 Quote 6: Alexander Ljungqvist, Ira Rennert Professor of Finance, 11 Callout 2: Selected Quotes on the Importance of Innovation NYU Stern School of Business 11 Callout 3: The Importance of Innovation – Organisation for 20 Quote 7: Piyush Tantia, Executive Director, ideas42 Economic Co-operation and Development (OECD) Business and 21 Quote 8: Margaret Miller, Senior Economist, Financial Inclusion Industry Committee (BIAC) Global Practice, World Bank Group 12 Callout 4: Four Types of Innovation – The OECD’s Oslo Manual 25 Quote 9: Thomas Deinet, Executive Director, Hedge Fund 16 Callout 5: Defining Financial Innovation – Lerner and Tufano Standards Board 19 Callout 6: Assessing and Quantifying the Benefits of Financial 27 Quote 10: Tim Wyles, Partner, Oliver Wyman – Financial Services Innovation 32 Quote 11: Peter Tufano, Peter Moores Dean and Professor of 22 Callout 7: Knightian Uncertainty Finance; Saïd Business School, University of Oxford 22 Callout 8: Increased Uncertainty in Financial Innovation 34 Quote 12: Peter Tufano, Peter Moores Dean and Professor of 23 Callout 9: Uncertainty and the Financial Crisis Finance; Saïd Business School, University of Oxford 25 Callout 10: Structured Finance – Defining Terms 36 Quote 13: Piyush Tantia, Executive Director, ideas42 28 Callout 11: Regulatory Arbitrage and Financial Innovation 39 Quote 14: Margaret Miller, Senior Economist, Financial Inclusion Global Practice, World Bank Group 32 Callout 12: Post-crisis Attitudes to Financial Innovation – Example Statements 41 Quote 15: Alexander Ljungqvist, Ira Rennert Professor of Finance, NYU Stern School of Business 35 Callout 13: M-PESA 43 Quote 16: Daniel Hofmann, Economic Counsellor, International 42 Callout 14: The Three Pillars of Success for Innovation Association of Insurance Supervisors 50 Callout 15: Regulatory Requirements for the New Product 44 Quote 17: Thomas Deinet, Executive Director, Hedge Fund Approval Process Standards Board 52 Callout 16: Incentive Misalignment and the Financial Crisis 46 Quote 18: Jennifer Tescher, President and CEO, Center for Financial Services Innovation Table of Figures 50 Quote 19: Bill Shew, Partner, Oliver Wyman 13 Figure 1: Innovation Horizons 55 Quote 20: Tim Wyles, Partner, Oliver Wyman – Financial Services 24 Figure 2: How the Banking Crisis Evolved 57 Quote 21: Daniel Hofmann, Economic Counsellor, International 26 Figure 3: US Outstanding Mortgage Debt by Securitization Association of Insurance Supervisors 58 27 Figure 4: Global CDO Issuance Quote 22: Jennifer Tescher, President and CEO, Center for Financial Services Innovation 29 Figure 5: Outstanding CDSs 2001-2011 34 Figure 6: Number of Uninsured and Uninsured Rate in the United States: 1987 to 2010 35 Figure 7: Global Micro-finance Overview 41 Figure 8: A Framework Approach 42 Figure 9: The Innovation Process 63 Figure 10: Capital Markets in the EU and the US 69 Figure 11: Two Eras of R&D Productivity in Pharma 69 Figure 12: Industry R&D Productivity Has Dropped in Pharma 77 Figure 13: CDO Structure Based on MBS 2 Rethinking Financial Innovation Preface Since the recent financial crisis, a typical reaction to any mention of financial innovation has been: “Did financial innovation not cause this crisis?” or “Does the world really need further financial innovation?” While many academic studies have confirmed the benefits of financial innovation and its importance to the development of financial systems, there is no doubt that some innovations in financial services mutated from their original purpose and contributed to the crisis. Therein lies 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. In this spirit, the chief executive officers of many of the world’s leading
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