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Technological Change and Financial Innovation in Banking: Some Implications for Fintech

Financial intermediation has changed dramatically over the past 30 years, due in large part to technological change. The paper first describes the role of the financial system in a modern economy and how technological change and financial innovation can affect social welfare. We then survey the empirical literatures relating to several specific financial innovations, broadly categorized as new production processes, new products or services, or new organizational forms. In each case, we also include examples of significant fintech innovations that are transforming various aspects of banking. Drawing on the literature on innovations from the 1990s and 2000s informs what we might expect from recent developments.

Financial intermediation has changed dramatically over the past 30 years, due in large part to technological change arising from advances in telecommunications, information technology, and financial practice. This technological progress has spurred financial innovations that have altered many financial products, services, production processes, and organizational structures. To the extent that such financial innovations reduce costs or risks, social welfare may be improved. Of course, many financial innovations fail owing to fundamental design flaws or simply being replaced by better alternatives. A good example of technological change that has been dramatically reshaping the financial services industry is the ongoing shift from relying on human judgment to automated analysis of consumer data. This has taken what had been largely local markets for banking services and opened them up to nationwide competition from other banks and nonbank financial institutions. For example, retail loan applications are now routinely evaluated using credit scoring tools built using comprehensive historical credit registry databases. This automated approach eliminates the need to have a local presence to make a loan and substantially reduces underwriting and compliance costs for lenders, and the resulting data can be leveraged to improve further their risk measurement and management. Such a reliance on hard information also makes underwriting transparent to third parties and hence facilitates secondary markets for retail loans through securitization, which allows nonbank firms that lack deposit funding to compete via capital market financing. Given the growing importance of technology to financial services, it is perhaps not too surprising that the latest trend has been for technology-based firms to offer financial services, a development that is often called “fintech”. Many fintech firms combine automated analysis of retail customers with more user-friendly interfaces to provide services that are more convenient, and sometimes lower cost, to consumers. For example, “marketplace lending” platforms have emerged as a new organizational form that attracts borrowers with a simplified loan application process, leverages credit scoring tools to analyze these applications, and then matches creditworthy borrowers directly to investors. Furthermore, in some jurisdictions, machine learning (artificial intelligence) is now being leveraged to further improve retail loan risk measurement. Another set of recent technological developments are being touted as having the potential to have an even more fundamental impact on the financial system, potentially eliminating the need for trusted third parties such as banks. Whether and to what extent blockchains and cryptocurrencies will disrupt the existing financial system remains to be seen, as the technology is too new and immature to draw firm conclusions. However, the potential benefits of cryptocurrencies and blockchain technology are sufficient to attract considerable interest from tech-knowledgeable individuals, large financial organizations, and even major governments. This chapter surveys the research literatures pertaining to several specific financial innovations that have appeared in recent decades that were specifically driven by technological change. Particular attention is paid to innovations that may provide insights into the prospects for certain widely discussed fintech applications. To set the stage, we begin by providing some additional clarity about what is meant by financial innovation.

The operation of a financial system involves real resources employed by financial intermediaries; and a large share of these resources are expended in the data collection and analyses to deal with problems of asymmetric information. There are also uncertainties about future states of the world that generate risks that represent costs to risk-averse individuals. Hence, new or improved financial (i) production processes, (ii) products and services and (iii) organizational structures that can better satisfy financial system participants’ demand and reduce costs and risk processes should generally be welcomed. Viewed in this context, Frame and White (2004) define a financial innovation as “something new that reduces costs, reduces risks, or provides an improved product/service/instrument that better satisfies financial system participants' demands.” Importantly, Tufano (2003) emphasizes that financial innovation includes the process of both invention (the ongoing research and development function) and diffusion (or adoption) of new products, services, or ideas. The centrality of finance in an economy and its importance for economic growth naturally raises the importance of financial innovations (and their diffusion).1 Finance facilitates virtually all production activity and much consumption activity; and so improvements in the financial sector can have direct positive implications for an economy. Moreover, an improved financial sector can encourage more and better saving and investment decisions, making financial innovation even more valuable for an economy. This positive view of financial innovation has been discussed in a number of articles, including: Van Horne (1985), Miller (1986, 1992), Merton (1992, 1995), Tufano (2003), Berger (2003), and Frame and White (2004). However, the recent global financial crisis has led some observers to cast doubt on the usefulness of most financial innovation – seeing such activity as being largely associated with financial malpractice and instability (e.g., Krugman 2007; Volcker 2009).2 This negative view focuses on the “dark side” of financial innovation, which some view as the root cause of the recent Global Financial Crisis. While such a reevaluation is natural in light of the crisis, it is important to recognize that not every financial innovation will be welfare-enhancing or successful. Innovation involves trial-and-error, and failures can be costly – especially for widely diffused innovations (e.g., Lerner and Tufano, 2011). So, financial innovation should more accurately be viewed as likely being beneficial “on net”. Consistent with these conjectures, Beck, et al. (2016) conduct a cross-country analysis and find that financial innovation is associated with higher (but more volatile) economic growth and with greater bank fragility. Campbell (1988) offers four environmental conditions that are conducive to financial innovation: The first relates to underlying technologies and the ability of their improvement to increase efficiency. For example, the information technology revolution has facilitated the creation and use of “big data” and applied statistics for financial risk measurement and management; and machine learning is now used to leverage the data further. A second condition is an unstable macroeconomic environment, as the concomitant fluctuating asset prices are likely to spur risk-transfer innovations. A third condition is regulation, which can inhibit some innovations and encourage others (often as a mechanism to avoid regulation). Finally, taxes can spur financial innovations to the extent that they create incentives to repackage (or re-label) specific income streams so as to reduce tax liability. Over the past 30 years, each of these environmental conditions was markedly altered and resulted in substantial changes to the practice of financial intermediation. This remainder of this essay focuses mostly on Campbell’s first environmental condition: the role of technological change in driving financial innovation.

The past 30 years have witnessed important changes in financial institution production processes. The use of electronic transmission of bank-to-bank retail payments, which had modest beginnings in the 1970s, has exploded owing to greater retail acceptance, online banking, and check conversion. In terms of intermediation, credit bureau data have been used to create credit scores that increasingly substitute for manual underwriting – and this has been extended even into historically relationship-oriented products, such as small business loans. This trend toward hardening information has facilitated deep secondary consumer loan markets in the United States and has provided key inputs for risk management systems. Recently, the advent of blockchain/distributed ledger technology and significant advances in artificial intelligence/machine learning has raised important questions about the future of financial intermediation.

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