Technology, Regulation Likely to Spur More Financial Innovation

After taking a backseat to financial stability concerns since the financial crisis, financial innovation is poised for renewed prominence as long as there is not another systemic shock. To better understand how future innovation might unfold, Atlanta Fed economist Larry Wall recently examined two major sources of past innovation in banking services: regulation and technology.

Newer innovations praised, pilloried
Many recent forms of innovation designed to avoid regulation justifiably earned a bad name, Wall, executive director of the Center for Financial Innovation and Stability at the Atlanta Fed, writes in the February issue of Notes from the Vault. Nonetheless, in years past many economists praised some methods of regulatory innovation that helped to lower compliance costs. This more favorable view resulted largely from ideas that helped to force the repeal of laws that restricted competition.

"Innovative firms developed ways of avoiding these limits on competition that both boosted their profits and benefited the users of financial services," Wall writes.

Money market mutual funds, for example, overcame regulatory limits on interest paid to small investors, according to Wall.

Technology has fueled innovation in various ways
Technology has long been an important driver of financial innovation. For instance, the automated teller machine was introduced in the 1960s and has fundamentally altered retail banking. Also, advances in computer technology have helped to reshape the consumer banking experience since the early 1970s, when virtually all receipts and payments were some form of paper, Wall writes. As of 2010, nearly 94 percent of households used electronic payments such as ATMs, debit cards and automated bill paying.

Finally, technological advances have been critical in obtaining and manipulating the mountains of data required to build statistical models, and in performing timely calculations of complex valuation and risk measurement formulas, Wall notes.

While technology will continue to spur financial innovation, regulation will probably play an even bigger role, Wall writes, chiefly because the variety and sheer volume of regulations enacted after the financial crisis—3,500 pages, by some measures—give financial services providers enormous incentive to innovate.

March 12, 2014