Story by Steve Wunker
With Congressional negotiators reaching agreement early this morning on key provisions of the U.S. financial overhaul, it is a good time to weigh the impact of the bill on innovation in this sector.
Many commentators have predicted that the impact of the financial overhaul on innovation might be dire. Others have indicated that reducing innovation might actually be a good thing, given that innovative financial services played a key role in the economic crisis of 2008. Both of these assessments seem to miss the mark.
The 2000-page bill is extremely complex, and a blog post cannot do justice to all the intricacies. At a high level, the bill will curb banks’ ability to profit from proprietary trading, creating complex derivatives, pushing consumers into costly products, or charging hefty fees to merchants accepting debit cards. Banks, particularly big banks, will earn far lower profits in these areas, which represent key financial services innovations from the past two decades.
But what about the financial overhaul innovation impact going forward? While it was relatively easy for banks to make money (prior to 2008) by innovating in established product lines, such as through creating seemingly infinite varieties of mortgages, there have been few new product lines emerging from large banks, nor have these institutions paid much attention to the 7.7% of unbanked or 18% of underbanked U.S. households. Instead, some of the more creative approaches have come from non-bank institutions ranging from economic development groups to hedge funds. Witness for instance the alternative to payday lending created by Kentucky’s Mountain Association for Community Economic Development, which embeds a savings product into a relatively inexpensive short-term loan.
The bill imposes fewer restrictions on non-bank financial institutions. This is a double-edged sword. On the one hand these groups have many degrees of freedom to innovate. On the other hand they were so innovative in the past in part because they had to play the game differently from the big banks, who had inherent advantages from their low cost of capital. With the big banks now having fewer routes to generate line extensions in their core business, the periphery of financial services might become more competitive.
Big banks will no doubt try to cut costs from their systems, and much of their energy will focus on operational efficiency. They will also gain a short-term bump through growing non-interest revenue such as checking fees. Yet cost-cutting is not the way to satisfy the most creative staff in these institutions, who will also recognize that the exceptional compensation of years past came through growing revenues, not slashing expenses. And there are competitive and regulatory dangers in being too aggressive on fee revenue. To create growth, banks will need to look beyond their cores. This means catering to non-traditional customers, in ways other than the traditional luring of them through free checking accounts and making money on other offerings. It may also mean looking to non-traditional areas such as risk protection (let us not call this “insurance” for fear of thinking too narrowly), asset finance, and short-term investment.
Altogether, the financial overhaul’s shake-up should create new pressures to innovate, for both banks and non-banks. We may no longer have 20 types of mortgages (not such a bad thing), but we will have institutions focusing on the vast non-consumption that continues to bedevil financial services of all types. This is the most promising sort of innovation for both financial institutions and consumers.