The rapid international expansion by financial services firms since the early 1991s has occurred in the absence of any consistent evidence of such growth being associated with performance gains. Consolidation has been a fact of life in the financial services sector in recent years, and these structural changes in the industry have created the ample strategic turbulence that has confronted senior management teams and boards of banks, insurance companies, asset managers and securities firms.
The origins of financial innovations have attracted little empirical study. This study will cover Opportunism and imitation those are identified as the key drivers of cross border expansion, suggesting that internationalization strategies need to be based on a more rigorous analysis of the sources of cross-border value creation.
The evidence suggests that smaller firms account for a disproportionate share of the innovations. Less profitable firms innovate more, though in the years subsequent to the introduction of the innovation, the profitability of the innovators increases significantly
This study is likely to examine which institutions were the key financial innovators between 1991 and 2009.
Based on an empirical study in the financial services sector this study will describe how financial companies organize their innovative processes and what barriers to innovation can be identified in banks and insurance companies.
Introduction:
In the industrial era, up until the mid-1980s, most business firms enjoyed the luxury of a fairly stable operating environment with a limited or predictable rate of change. Such a condition of continuity made life for managers easy, as they could rely on good forecasts not only for developing a business strategy but also for the planning and control of their operations. To this end sophisticated management methods were developed over the years to carry out these business functions with increased efficiency and effectiveness.
This approach, however, did not work well in times of discontinuity, which during the industrial era was the exception rather than the rule. The conventional wisdom for success was to select a strategy based either on cost leadership or on differentiation in order to maximize profits (Porter, 1985). However, after the mid-1980s unexpected things began to happen. Rapid advances in technology, especially in computers and communications, began to change the nature of many business activities from analogue to digital. Furthermore, government deregulation introduced in key industries, i.e. in transportation and communication, initiated the breakdown of many traditional trade barriers. The collapse of the Berlin Wall in 1989 signaled the arrival of the global economy. This combined effect of major technological and economic developments created new waves of dramatic change and turbulence, introducing new interdependencies and numerous interactions among participating business actors. In the face of the ensuing complexity and uncertainty of such interaction outcomes, many familiar business principles and modes of operation lost much of their force and relevance. In the words of Boston Consulting Group consultants, most firms in the global economy are now forced to compete 'with everyone, from everywhere, for everything' (Sirkin et al., 2008).
Innovation Becomes the New Competitive Edge
In the business environment of a global economy, the strategic objective for most business firms, up until the onset of the current global economic crisis, was that of growth, i.e. the increase in revenues and shareholder profits. Under conditions of continuity this desired growth could be generated (1) by improving a firm's total productivity to reduce the costs of resources used; and (2) by improving the quality of products and services to stimulate greater demand. Achieving these goals for over two decades was made easier internally by the systematic use of new approaches such as TQM and externally by an abundance of capital.
However, in a continually changing business landscape the means to achieve the desired growth could no longer be those used in the past. In the post-war period the pursuit of excellence in the quality of products and processes was responsible for the Japanese manufacturing miracle which made that country the world's second biggest economy. Other countries also benefited substantially from the adaptation and practice of Japanese style quality management. In the turbulent era of the global economy quality is no longer the primary competitive weapon we knew in the industrial era. Quality in our time has simply become just the ticket for admission to a new more dynamic competitive arena. Similarly, productivity which was a top priority in the post-war era, closely correlated with a firm's economic health and a country's standard of living, has now become only a prerequisite to attain acceptable cost levels in order to compete.
Peter Drucker in 1985 was the first to diagnose that the world economy had entered an era of discontinuity. Accordingly, he argued that the past could no longer be assumed to be a reliable guide for the future. Drucker proposed innovation, rather than quality or productivity, as the unique competitive approach to survive the ensuing complexities and uncertainties of the new era of discontinuity (Drucker, 1985). More recently, Gary Hamel in his book, The future of management, has also identified innovation as the key core competence for success, stating that without it companies die (Hamel, 2007). India's much improved economic performance and prospects are a direct result of its belated market reforms. These only got going in 1991, in response to a macroeconomic crisis. Since the early 1990s, reforms have proceeded in stops and starts - slow and fitful compared with China, but fast and wide-ranging by pre-1991 Indian standards.
Basic Kinds of Innovation
Innovations come in different forms and have different impacts for the organization introducing them and for those affected by the increased value they provide. A useful classification for recognising the different kinds of innovation is based on the criteria shown in Figure 1. These refer to the technology used, the aspect(s) of the business model affected and the degree of impact they have.
An innovation system, as shown in Figure 2, is defined by key inputs (new ideas, knowledge, skills, investments, etc.), transformed by an innovation process into valuable for stakeholders' outputs (products/services, processes or business models) on a regular rather than an on/off basis. The innovation process is not complete until an idea has been fully developed and converted to cash in the market. To evaluate the innovation system's performance we need a set of criteria for screening proposed ideas and metrics meaningful for each business firm to assess the quality, the efficiency, and the effectiveness of the innovation process.
Globalization of Financial Services
Like other parts of the service sector, Globalization in financial services has lagged behind that of manufacturing. But the pace of international expansion among financial services companies - banks and insurance companies in particular - has accelerated significantly since the early 1990s. Propelled by international expansion, financial services companies heavily populate the ranks of the world's largest companies: by early 2009, the world's 30 biggest companies in terms of assets were all financial services companies, and almost all were multinational enterprises (see Table 1).
Given the lack of consistent evidence that Globalization improves the performance of financial services companies, our aim is to understand the causes and effects of this wave of cross-border expansion with the intention of deriving lessons as to how financial services companies can better formulate and implement their Globalization strategies. We focus on finding answers to three questions: what are the forces that have driven the rapid Globalization of the financial services firms since the early 1990s?; what are the sources of value creation from Globalization in financial services and how significant are the gains?; and what challenges do multinational financial services firms face in designing organizational structures and management systems to exploit the potential returns from their international scope?
During 2007, our study was overtaken by global events. The credit crunch of 2007 imploded into the financial crisis of 2008, throwing the entire financial sector into turmoil, and this 'structural break' in the evolution of the financial services sector severely disrupted our study of its globalization strategies. Casualties of the financial crisis included several leaders of international expansion - the Royal Bank of Scotland, AIG, Lehman Brothers and the main Icelandic banks, among others.
Many of the strategies that had appeared successful in the run-up to the credit crunch in the summer of 2007 proved unsustainable in an environment of credit shortage and risk aversion. It seemed unlikely that conclusions based on pre-2007 strategies and performance would have much relevance in a post-crash world. The crisis has been a humiliating experience for many senior executives charged with managing the world's financial institutions. It has also been humbling for students of strategic management. The scale of the calamity that engulfed the sector - and the fact that so few experts were able to identify flaws in the strategies being pursued until well after its onset - point to the need to revisit frameworks for strategic analysis and how they are applied to the financial services sector.
The financial crisis of 2008 also presents the opportunity to use our findings on internationalization strategies to shed light on broader issues of strategic management among financial services firms. The widespread strategic failures in the sector include excessive financial leverage (including the use of off-the-balance-sheet financial vehicles), ill-considered acquisitions, diversification based on dubious synergies, flawed risk management systems, and problems of vertical and horizontal coordination. Globalization represents one dimension of this broader strategic mismanagement that displays several characteristics of bigger problems, including: acquisition-led growth (the appendix shows that over half the major mergers and acquisitions between financial services firms were across national borders), imitative behaviour, and a willingness to extend company boundaries beyond the experience base of top management and the capacity of corporate management systems and (in particular) their risk management systems.
Clearly, the global subprime crisis and the resulting credit crunch have exerted (and are still) a major influence on the international strategies of financial services. Several big financial institutions - AIG, Citicorp and RBS - have sold overseas businesses to make up for their massive write downs: others - Bank of America, Barclays, Nomura - have taken advantage of distressed assets to greatly extend their international scope. Ownership structures have also changed dramatically, as home governments, sovereign wealth funds, and passive investors from emerging economies have acquired major shareholdings in leading financial services firms.
The expanded role of governments and central banks in the financial services and more stringent regulatory regimes will continue to change the competitive environment of the sector. Yet, despite the ongoing turbulence, the fundamental strategic issues concerning the sources of value creation from internationalization and the means for exploiting them remain unaltered. The financial crisis has provided further reinforcement to our basic observation that building a successful international financial services firm presents a difficult challenge. Top management cannot rely on any general benefits conferred by international scope, while the financial crisis has revealed the weaknesses of internationalization based on opportunism and the acceptance of increased risk. We will show that internationalization does have the potential to create value, but needs to be based on careful strategic decision making that takes account of the value drivers of cross-border business and the firm's potential for creating competitive advantage in foreign markets.
The extent of gains from cross-border integration and the costs of adapting to national markets also influence the choice of entry mode: acquisition, joint-venture, strategic alliance, or the establishment of 'greenfield' units. Greenfield entry is most conducive to exploiting benefits from cross-border integration, but where national market differences are substantial, acquisitions predominate, which raises the issue of whether the gains from cross-border integration are sufficient to offset acquisition premiums. Finally, we address the challenges of implementing Globalization strategies.
The combination of multiple sources of cross-border value creation and diverse national market conditions creates major complexities for the design of organizational structures and management systems. Choosing to run international financial services companies as a network of separate national subsidiaries fails to exploit the benefits of cross-border integration, while operating as an integrated global company results in failure to adapt to national market differences. Finding an optimal position between these extremes has proved elusive for most financial services companies, especially those with widely diversified product portfolios. Further problems arise from the central role of risk in the management of financial services companies.
Innovations In The Financial Services
Briefly reviewing, a financial innovation may be either a new product, such as zero coupon bonds, or a new process, such as a new delivery system for electronic funds transfer. With financial innovations, very seldom do we observe the introduction of something entirely new. Rather, innovation typically involves modification of an existing idea, either a product or a process. The dramatic technological breakthroughs that occur in the product markets usually are not found in the financial markets.
For an idea to be viable as a financial innovation, it must make the markets more efficient in an operational sense and/or more complete. The purpose of financial markets, of course, is to channel the savings of society to the most profitable investment opportunities on a risk-adjusted return basis. These opportunities may originate in the private sector, and involve a rate of return on investment, or in the public sector, where a social return is involved. In all cases, there is a cost to the financial intermediation process by which savings flows are allocated; the process is not frictionless. This cost is represented by the difference, or spread, between what the ultimate saver receives for funds and what the ultimate borrower pays (holding risk constant), as well as by the inconvenience to one or both parties.^ A financial innovation may make the market more efficient by reducing the cost of financial intermediation to consumers of financial services. Either the spread, as defined above, is lowered or inconvenience costs are reduced.A second foundation for financial innovation is the movement toward market completeness.
A complete market exists when every contingency in the world corresponds to a distinct marketable security.^ In contrast, incomplete markets exist when the number and types of securities available do not span these contingencies. In other words, there is an unfilled desire for a particular type of security on the part of an investor clientele. An example would be the desire for zero coupon bonds by pension funds prior to 1981. If the market is incomplete, it pays a financial intermediary or a direct borrower to exploit the opportunity by tailoring security offerings to the unfilled desires of investors, whether those desires have to do with maturity, coupon rate, protection, call feature, cash-flow characteristics, or whatever. As with most things, it is a matter of degree. The sheer number of different types of securities necessary to make the market truly complete is bound to result in an incomplete market in the real world. The issue is whether a sufficient number of time-state claims exist to make the market reasonably complete, not entirely so.
Thus, financial innovations occur in response to profit opportunities which, in turn, arise from inefficiencies in financial intermediation and/or incompleteness in financial markets. If markets are truly competitive, the profitability of a financial innovation to its original promoter will decline over time. A profitable innovation, of course, invites others to enter the marketplace with a like product or process. As this occurs, promoter profit margins erode and financial service consumers increasingly benefit vis-a-vis the promoter. In other words, as a
financial innovation becomes seasoned, promoter profit margins decline, and the benefits of the innovation increasingly are realized by the consumer. At least that is how it should work, and usually does.
The significance of financial innovation is widely recognized. Many leading scholars, including Miller (1986) and Merton (1992), highlight the importance of new products and services in the financial arena. These innovations are critical not just for firms in the financial services industry, however. Indeed, financial innovations enable firms of all industries to raise capital in larger amounts and at a lower cost than they could otherwise. Empirically, Tufano (1989) shows that of all public offerings in 1987, 18% (on a dollar-weighted basis) consisted of securities that had not been in existence in 1974.
Despite the acknowledged economic importance of financial innovation, the sources of such innovation remain poorly understood. In a recent review article, Frame and White (2004) are able to identify only 39 empirical studies of financial innovation. Moreover, this literature concentrates largely on the ''back end'' of the innovation process, focusing on the diffusion of these innovations, the characteristics of adopters, and the consequences of innovation for firm profitability and social welfare. Frame and White identify only two papers on the origins of innovation, namely, Ben-Horim and Silber (1977) and Lerner (2002).
The paucity of research in this area contrasts sharply with the abundant literature on the sources of manufacturing innovation. This neglect is particularly puzzling given the special circumstances surrounding financial innovation. Several considerations- discussed in detail in Section 2-suggest that the dynamics of financial innovation are quite different from those in manufacturing. Together, these considerations suggest the need to examine financial innovation as a phenomenon in its own right.
The origins of financial innovation
It is reasonable to assume that the dynamics of innovation in the financial services industry are quite different from those in manufacturing as a whole. Unfortunately, to date the literature on financial innovation provides relatively little guidance as to which institutions should be more prolific innovators. At least three substantial differences exist between innovation in financial services and manufacturing:
Appropriability: The financial services industry has historically differed from the bulk of manufacturing industries with regard to the ability of innovators to appropriate their discoveries. Until recently, financial firms have been very limited in their ability to protect new ideas through patents. Even when firms did apply for patents, they frequently did not expect to be able to enforce them readily. As a result, new product ideas have diffused rapidly across competitors (Tufano, 1989).
While a theoretical analysis by Herrera and Schroth (2002) New York University. argues that even when inventions cannot be patented, investment banks will have considerable incentives to develop new products, it might be anticipated that the lack of effective patent protection would shape the incentives to innovate. Regulation: Many product innovations in financial services have been subject to detailed review by public regulatory agencies. While certainly such reviews are not unknown in manufacturing (e.g., pharmaceuticals), the prevalence of regulatory scrutiny is greater in this context. These reviews may raise the barriers to innovation, particularly for younger and inexperienced firms that may find that such reviews strain their resources. Such regulatory changes may also serve as incentives for financial innovation, however, as firms seek to find their way around such constraints.
Collaboration: In many segments of the financial services industry, firms frequently engage in collaborative activities, whether syndications of innovative securities or joint ventures to market new products. The creation of standards is also important in facilitating interaction among financial institutions. While collaborations are certainly also seen in manufacturing industries and standardization is critical as well in information technology, the ubiquity of these relationships in financial services may shape the incentives to innovate and the nature of innovations.
While an extensive theoretical literature examines financial innovation (see reviews by Harris and Raviv, 1989; Allen and Gale, 1994; Tufano, 2003), the role of institutions has received little scrutiny. Tufano (2003), in fact, quotes Franklin Allen's observation that much of financial economics acts as if financial institutions do not exist, though he acknowledges that this observation does not perfectly characterize the literature on innovation. Ross (1989) . Many of the studies seek to understand the impact on innovation of what Miller (1986) refers to as the ''grain of sand in the oyster,'' that is, external shocks such as shifts in taxes or user demands. The nature of the institutions that undertake the innovations has been less scrutinized.
The conclusions offered by the theoretical work that examines the question of which financial institutions innovate are mixed. The question that has been most explored is whether institutions that are more or less well positioned competitively will account for the bulk of the innovations. Bhattacharyya and Nanda (2000) argue that investment banks with greater market power and more secure relationships with their customers are likely to innovate. Silber (1975, 1983), on the other hand, argues that the firms most constrained in their abilities to profit in the product market- which, he implies are the weakest and smallest firms-will have the greatest incentive
to introduce new products and services, and in turn should be the most innovative. The other determinants of innovation discussed above, that is, the impact of financial constraints and knowledge spillovers, have largely been unexplored in the context of financial innovation.
Virtualization - A new Era in Financial Services
Future of Financial Innovations:
The financial innovation will continue to flourish, as financial markets and the financial services industry become even more competitive. The essential ingredient-change-is all about us. Changes in regulations, tax laws, and technology continue to unfold at almost a frightening clip. Inflation is more stable now than it has been in recent years, but we know this can change rather quickly. Interest rates, both nominal and real, behave in ways difficult to explain by past experience. International events continue to create uncertainty. In this atmosphere, financial innovation should thrive. However, the thrust of financial institutions will shift, as more marketable, depersonalized, rate-sensitive instruments are offered. Further shakeouts and consolidations of financial institutions are inevitable. The failing business doctrine has allowed large financial institutions to acquire organizations nationwide, thereby circumventing laws designed to preclude national deposit institutions. Recent regulatory changes have opened up the insurance industry to competition from other financial institutions. However, concern with the financial stability of banks, thrifts, insurance companies, and security firms has led to recent cries for reregulation.
The increasing sophistication of financial service delivery systems is making efficiency and breadth of services important. These characteristics sometimes can be achieved by merger or by linking together with other financial institutions to provide nationwide or even international service. Such joint ventures are particularly evident in the electronic funds transfer, credit card, and mutual fund areas. The differences between depository institutions, investment banks, insurance companies, telecommunication companies, mutual funds, and retailers are diminishing; the areas of business overlap are expanding. Geographic and product differentiation, once the hallmarks of the financial services industry, are becoming increasingly difficult to sustain." Whether reregulation occurs and reduces this trend remains to be seen.
On balance, there is every reason to believe that the rapid and far reaching financial innovations of the last six years will continue. The times are ripe for such occurrences. Different innovations to be sure. For one thing, deregulation already is well along the road to completion. The initial, rather sweeping, changes will be followed by refinements, or perhaps even by reversals if reregulation occurs. In the unfolding process of financial innovation, I imagine that we will continue to observe excesses of the sort described. However, these may not be as large as in the past. The marketplace for new ideas should become wiser, what with increased experience with financial innovation. Hopefully, it will become sharper in its ability to discriminate. Hefty and sustained promotion fees, misallocation of resources, and the bad image finance conveys to some in our society as a result of promotion abuses are things we could better do without. Still the ultimate discipline and correction must come from the market. While the times are ripe for financial innovation, they also are receptive for financial research. Formal tools of analysis can be brought to bear to give us more insight, both theoretically and empirically, into the rapidly changing financial environment in which we live. It is exciting, at the same time sobering, to realize that macro finance considerations are unavoidable in a field largely dominated heretofore with micro considerations.
