Financial Planning > Behavioral Finance

Rethinking Financial Innovation to Reduce Negative Outcomes

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The World Economic Forum, held in Geneva, Switzerland earlier this year, hit on a key idea for the markets: they need to rethink financial innovation. 

“The world is currently facing a conundrum: on the one hand, financial innovation is broadly beneficial and is needed to address many of society’s challenges; on the other, negative outcomes associated with financial innovation are too serious to ignore,” said Giancarlo Bruno, Senior Director and Head of the Financial Services Industry, World Economic Forum.

The following are key findings pulled from the report:

  1. Innovation, almost by definition, introduces uncertainty
  2. This uncertainty occasionally gives rise to unintentional negative outcomes
  3. The relationship of the financial services sector to the rest of the economy makes it vital to reduce the likelihood of negative outcomes with widespread consequences
  4. Unintended consequences or negative outcomes cannot be predicted reliably for individual innovations
  5. Concerns over possible negative outcomes do not require an entirely new “innovation governance framework,” but enhancements to existing governance procedures. This is best done by adapting existing risk management mechanisms and other processes to be more sensitive to the specific contribution of innovation to uncertainty and risk
  6. “Positive innovation” continues to be necessary. It can provide opportunity in four key areas: financing and growing the private economy; promoting inclusiveness; increasing efficiency, access and the customer experience; and rebalancing risk across sectors of the economy

In conclusion, the “report takes the position that the primary responsibility for improving the management of financial innovation lies with banks and insurers,” said Stefan Lippe, Former Chief Executive Officer, SwissRe and Chair of the Steering Committee, Switzerland. “It provides a taxonomy of potential negative outcomes and recommends initiatives for companies, industry bodies and regulators. For institutions, it recommends improvements to existing enterprise risk management techniques, new product impact assessments, better design of incentives, and enhanced consumer orientation.”

“Managing financial innovation is like being in a game where you think you know the odds of success, but you don’t really even know the rules. Fortunately, there are some mechanisms available to deal with this challenge,” said Peter Carroll, Partner at Oliver Wyman, USA.

The following are recommendations from the report for banks and insurers:

  1. Review and adapt enterprise risk management (ERM) to address the incremental risks and uncertainties introduced by financial innovation, starting with careful, step-by-step re-evaluation of the ways in which risks are enumerated, measured and managed and with specific emphasis on assessing the ways in which innovation introduces uncertainty.
  2. Revisit new product development approval processes to address the idiosyncrasies of financial innovation properly
  3. Redesign incentives to provide the right motivation
  4. Recommit and refocus innovation efforts to be customer oriented