The Seven Pillars of Financial Innovation

By Warren Edwardes

September 2007 Capital Magazine, Dubai UAE

In the financial market, the barriers to product development are incredibly low. Unlike in the industrial world, a manufacturer of a financial product such as a fixed-rate mortgage or an inflation-linked deposit product does not have to create the product and stock shelves. Even in retail financial services, with the product offered at a fixed rate, the bank always has the right to withdraw the offer. The costs of producing a retail product are limited to the costs of stationary, staff training and computer systems. In the wholesale financial markets, the costs of developing products are even lower.

There are seven main pillars of financial innovation:

·        Competitive Innovation

·        Regulatory Innovation

·        Accounting Innovation

·        Taxation Innovation

·        Religious Innovation

·        Ignorance Innovation

·        Technological Innovation

 Competitive Innovation

 The largest institutions in any industry are often not the leaders in the early stages of innovation. But in a free market with low-cost ease of access though the Internet, unless firms can develop new financial instruments that meet the changing needs of the marketplace, they will be bypassed. It is no good just being on the right track; if you just stand there, you will be run over.

 Competitive innovation seeks to provide a firm’s clients with better solutions to their problems. Banks thereby hope to generate a higher market share or a higher profit by satisfying the customer’s needs – the much-touted “needs-driven approach.” I came across a bank marketing director who religiously stuck to this approach and proudly stated that he never mentioned products to customers. But at the end of the day, a bank’s marketing team has to provide a customer with a product or service.

 Regulatory Innovation

 One example of regulatory innovation is the Eurobond market that was created in London by the London merchant bank SG Warburg, as a result of two main forces. Firstly, there were regulatory restrictions and fiscal impositions in the US. Secondly, because of the Cold War, the USSR was not keen to invest its funds in the US. A relatively free Eurobond market was developed in London for borrowers and investors who wished to avoid US controls.

 In 1978, I got my first job in the balance sheet management department of a major British bank. At that time, there were very strict quantitative controls on bank lending in the UK. The growth in interest-bearing eligible liabilities (IBELs) was controlled, with strict penalties imposed by the Bank of England on banks that exceeded permitted growth. Several regulatory arbitrage schemes were employed to maintain bank lending but avoid paying penalties. The bank loaned money through bankers acceptances, which, if sold on, did not count as IBELs. Lending was also done through the bank’s Paris branch. Such offshore lending, even denominated in Sterling, did not count as IBELs. And where possible, lending was carried out between “make-up days,” the dates on which the monthly balance sheets were drawn up for Bank of England reporting purposes. This was to such an extent that the bank’s IBELs used to fall after the make-up days by as much as 30 per cent. My bank was the only UK bank that did not have penalties imposed on it.

 A number of products have also been targeted specifically at fund managers with tight regulatory controls. Many such managers are not authorised to use derivatives. But they can buy investments with built-in derivatives structures to provide them with the gearing and risk pattern they seek. Such products were designed specifically for some highly regulated investment funds. In some cases, individual institutional investors have bought entire issues of highly geared bonds.

 Accounting Innovation

 The Break Forward was a case of both accounting innovation and taxation innovation. Finance directors were reluctant to pay currency option premiums up front. After all, they did not have to do so for standard forward exchange contracts. So I developed the Break Forward out of a currency option with no explicit option premium. The premium was embedded in the packaged product, which consisted of two contracts: a forward contract at a rate worse than market and a “free” option to unwind. The cash value of the difference between the two contracts amounted to the future value of the option premium. Corporate treasurers knew what they were doing and understood that they were buying options. This was fully explained to them. But the Break Forward structure was easier to explain to boards of directors who had been comfortable with forwards.

 Taxation Innovation

 It is all very well coming up with solutions to customer problems, but unless a third party (the tax man) is contributing to the pot, the profitability of deals is often insufficient to justify the effort.

 Zero coupon bonds and deep discounted securities were initially tax-driven products, in addition to their portfolio immunisation benefits. In most jurisdictions, until fairly recently, capital gains were generally taxed much more favourably, if taxed at all, than income. Interest was converted into capital gains by various methods. Such schemes are no longer tax efficient. Taxation Innovation is on the wane, as many jurisdictions now have the right to retrospectively tax what they deem to be tax-avoidance schemes.

Religious Innovation

 Religious Innovation here largely refers to Islamic banking. But Islamic banking is more than just the prohibition of interest. In conventional banking terms, it is also about the introduction of a Profit and Loss system of banking or venture capital, equity investment or fund management.. However, numerous Islamic banking schemes amount to converting interest into capital gains perhaps through back-to-back or circular commodity trades on the grounds that “trade is permitted but Riba is forbidden” . These processes are very similar to the old tax minimisation schemes involving interest elimination.

 

Religious innovation is not just limited to Islamic banking. Many non-Islamic countries have usury laws to control maximum interest rates payable by consumers. And a number of ethical investment funds have been created to channel funds into firms that align with social causes.

 Ignorance Innovation

 As stated above, competitive innovation seeks to generate new customer solutions through a “needs-driven” approach. But what is often not obvious is that the “needs” referred to are those of the bank traders and directors’ bonuses rather than those of their customers. Ignorance innovation is plain and simple “ripping off” customers, not through any fraud or misrepresentation, but through creative financial engineering.

 

Perpetual Floating Rate Notes were issued by banks in the mid-1980s. FRNs traditionally had maturities between five years and 15 years. Naturally, they did not count as primary capital in the same way as retained earnings or shareholders’ funds. So banks issued FRNs, but with no maturity date. The structure was akin to preference shares but with floating rates. There was no obligation to repay the “loans” at any time. The ability of an investor to realise his investment crucially depended on an active and liquid secondary market. And this was limited, as banks that held other banks’ Perpetual FRNs found that their capital base was reduced by regulators in line with their holdings of such “Perps." Gradually, the true nature of these Perps dawned upon investors. They had bought bank liability instruments that they believed were almost like deposits, but paying 25 basis points over LIBOR. As investors stormed out of positions in the Perpetual FRNs, prices crashed within days to 80 per cent of the par value they had been trading. The yield was now a more reasonable, but still low, 250 basis points over LIBOR for bank equity. A case of what appeared to be regulatory innovation was really ignorance innovation.

 Technological Innovation

 Banking and finance today would be very different without the PC and other technological advances. There would be no cash machines. No Internet banking and even telephone banking. It would be impossible to calculate the price of currency options and credit and other complex derivatives and securitised structured without modern technology.

 But sophisticated technology on its own is no solution; it has to be correctly interpreted. And the limitations of the output must be understood. Perhaps the treasury management pendulum has swung too far towards blind faith in calculations that boards do not adequately understand, and more dangerously, these boards are too embarrassed to demand justification. Probabilistic models have to be understood for what they are.

 Innovation of new financial instruments by banks is necessary to avoid being left behind in the competitive marketplace. And there will be a number of genuinely useful products that meet customers’ needs. But if the banks selling the products or corporations buying these instruments do not understand why they are entering into such transactions and how to measure and control the risks generated by them, it would be better to steer well clear of them.

 The Race Goes to the Stumbler

 In the end, it is those who take risks and venture into the unknown who will provide the most startling innovations. Or as inventor Charles Kettering once said: " Keep on going and the chances are you will stumble on something, perhaps when you are least expecting it. I have never heard of anyone stumbling on something sitting down."

This article forms the basis for Chapter 3 of Key Financial Instruments: Understanding and Innovating in the World of Derivatives by Warren Edwardes.

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Warren Edwardes is CEO of Delphi Risk Management, a London-based financial instrument innovation and risk management consultancy. Edwardes' best-selling book, Key Financial Instruments: Understanding and Innovating in the World of Derivatives includes an appendix on Islamic banking as a case study on financial innovation. Edwardes has written and spoken widely on Islamic banking in London, the Middle East and in Malaysia. He is a Fellow of the Institute of Islamic Banking and Insurance, Governor and Honorary Publications Advisor.

He can be contacted at we@dc3.co.uk and more information is available at www.dc3.co.uk