Innovation

What Is 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 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 secularization.

Types

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.

Causes

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.

Examples

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.