Technological Change, Financial Innovation, and Diffusion in Banking

Working Paper 2009-10 March 2009 Abstract: This paper discusses the technological change and financial innovation that commercial banking has experienced during the past twenty-five years. The paper first describes the role of the financial system in economies and how technological change and financial innovation can improve social welfare. We then survey the literature relating to several specific financial innovations, which we define as new products or services, production processes, or organizational forms. We find that the past quarter century has been a period of substantial change in terms of banking products, services, and production technologies. Moreover, while much effort has been devoted to understanding the characteristics of users and adopters of financial innovations and the attendant welfare implications, we still know little about how and why financial innovations are initially developed. JEL classification: G21, O31, O33 Key words: technological change, financial innovation, banking I. Introduction The commercial banking business has changed dramatically over the past 25 years, due in large part to technological change. (1) Advances in telecommunications, information technology, and financial theory and practice have jointly transformed many of the relationship-focused intermediaries of yesteryear into data-intensive risk management operations of today. Consistent with this, we now find many commercial banks embedded as part of global financial institutions that engage in a wide variety of financial activities. To be more specific, technological changes relating to telecommunications and data processing have spurred financial innovations that have altered bank products and services and production processes. For example, the ability to use applied statistics cost-effectively (via software and computing power) has markedly altered the process of financial intermediation. Retail loan applications are now routinely evaluated using credit scoring tools, rather than using human judgment. Such an approach makes underwriting much more transparent to third parties and hence facilitates secondary markets for retail credits (e.g., mortgages and credit card receivables) via securitization. (2) Statistically based risk measurement tools are also used to measure and manage other types of credit risks--as well as interest rate risks--on an ongoing basis across entire portfolios. Indeed, tools like value-at-risk are even used to determine the appropriate allocation of risk-based capital for actively managed (trading) portfolios. This chapter will describe how technological change has spurred financial innovations that have driven the aforementioned changes in commercial banking over the past 25 years. In this respect, our survey is similar to that of Berger (2003). (3) However, our analysis distinguishes itself by reviewing the literature on a larger number of new banking technologies and synthesizing these studies in the context of the broader economics literature on innovation. In this way, the chapter is more like our own previous survey of empirical studies of financial innovation (Frame and White, 2004). We note that this survey is U.S.-centric, owing to our own experiences, the fact that many financial innovations originate in the U.S., and that most studies of such innovations rely on U.S. data. Before proceeding, it will be helpful to understand better what is meant by financial innovation. II. Background: The Role of Finance and Financial Innovation As noted by Merton (1992, p. 12), the primary function of a financial system is to facilitate the allocation and deployment of economic resources, both spatially and across time, in an uncertain environment. This function encompasses a payments system with a medium of exchange; the transfer of resources from savers to borrowers; the gathering of savings for pure time transformation (i. …