Financial Innovations: Engine of Growth or Source of Instability?

By

Mr. Birenjan Digal
Lecturer
Al-Ameen Institute of Management Studies
Bangalore-560027
 

Abstract

Economic and financial history is full of innovations that have, at least initially, caused instability and stress. But policy makers have also recognised that financial innovations have an important role to play in promoting efficiency in the financial intermediation process and thereby support overall economic growth. The challenge, as ever, is to make such rules as would protect and promote financial stability without stifling productive financial innovation. It is quite likely that sub-prime mortgages and mortgage securitisation, important financial concepts as they are but lately become notorious, re-emerge from the on-going crisis but with due checks and balances.

One of the key lessons from the global financial markets crisis for India and other emerging market economies, according to the Governor of the Reserve Bank of India, is to strike a fine balance between financial regulation and innovation.

True to the saying that too much of anything is good for nothing, the Governor points out that "the present crisis underscores the need for regulation staying ahead of the curve and for continually upgrading the skills and instruments for financial regulation and supervision. However, there is need for a note of caution here. There is a distinct risk that in trying to stay ahead of innovation, regulation may get so stringent that it stifles innovation. This is a risk we must guard against."

Implicit in this message of caution is an acknowledgement and indeed reiteration of the important role which financial innovation plays in promoting overall economic growth. In the backdrop of the extreme instability and systemic, global crisis which innovation in the US residential mortgage financing market has caused, such a reiteration of the useful role of financial innovation by the top financial regulator in the country is indeed welcome.

Innovation – an overview

Organizations with a sense of legacy and resilience need to reinvent themselves from time to time, if not continuously. So, in this competitive era and globalized world, it begets the question: how innovative can these companies become in order to sustain competitive advantages. The unknown premise for these companies is that innovation ensures superior performance and helps companies adapt to concomitant business and other external environment changes. To be sure, companies should not be blindsided by immediate and current business concerns or even by the structures of successful or robust business models but look to have a view of emerging business opportunities through the 'prism' of innovation. Also while the approach to innovation in the new business environment has to be smart, practical and continuous, the fact that innovation is relative to the size and hierarchical levels of an organization cannot be discounted. Verily, innovation has to be recognized as a priority of corporate strategic objectives and entire business visions.

Innovation – Define

A Convenient definition of innovation from an organizational perspective is given by Luecke and Katz (2003), who wrote:

"Innovation is generally understood as the successful introduction of a new thing or method. Innovation is the embodiment, combination or synthesis of knowledge in original, relevant, valued new products, processes or services.

For innovation to occur, something more than the generation of a creative idea or insight is required: the insight must be put into action to make a genuine difference, resulting for example in new or altered business processes within the organization, or changes in the products and services provided. A further characterization of innovation is as an organizational or management process. For example, Davila et al. (2006) wrote:

"Innovation, like many business functions, is a management process that requires specific tools, rules and discipline."

Innovation = Creativity * Risk Taking

National Knowledge Commission (2007) defines Innovation in the following manner:

"Innovation is defined as a process by which varying degrees of measurable value enhancement is planned and achieved, in any commercial activity. This process may be breakthrough or incremental, and it may occur systematically in a company or sporadically; it may be achieved by:

* Introducing new or improved goods or services or

* Implementing new or improved operational processes or

* Implementing new or improved organizational/managerial processes

in order to improve market share, competitiveness and quality, while reducing costs."

Innovation and competitiveness have a dynamic, mutual relationship. Innovation is result of competition and plays a key role in the achievement of success of organization. Innovation generates economic value, new jobs in the economy and culture or entrepreneurship. By virtue of its relationship with competitiveness, innovation emerges as a factor in promoting economic growth.

An International Innovation Ticker

Current business history has always shown resilient, smart and agile companies as the leaders of innovation. One is only too well aware of the fact that "innovation is the only way forward philosophies" of companies such as Nokia, Apple, Sony, Siemens, DoCoMo etc. These companies have always had a ken for the vicissitudes of economic cycles and recessionary phases by factoring in robust and feasible innovative strategies.

Ridding high on the buoyant economy, an overwhelming majority of the India Inc lists innovation among the top three strategic priorities as compared to their global counterparts, a survey says. Far ahead of other developing and developed economies of the world, India Inc is assigning strategic priority to innovation. About 91 per cent of the senior executives put innovation among the top three strategic priorities, "a joint India Innovation Survey by the Confederation of Indian Industry and Boston Consulting Group revealed. However, the BCG Global Survey, 2006 found only 71 per cent of the companies globally assigned innovation such a high strategic priority. The executives being surveyed put strong emphasis in creating and sustaining an ecosystem of innovation. By inference, tangible venture processes on the strength of strong R & D teams and developers should be backed and enough resources should be allocated to fuel the "Innovative Spirit".

In January 2009, the 2008-2009 Global Innovation Index was published It was created by Soumitra Dutta, a professor at French business school INSEAD, along with New Delhi based non-profit organization. The Confederation of Indian. The ranking is based on indices such as the number of internet users in a nation, the ease of doing business and the stability of banks. Every factor is then categorized as either an input or an output, with inputs indicating how conducive countries are to stimulate innovation (these include institutions and policies, human capacity, infrastructure, technological translate innovation into benefits-like knowledge, competitiveness and wealth. The top ten countries are listed below:

Table 1: Top 10 Innovative Countries

The relentless drive and zest for innovation have resulted in the development of the Internet enabled mobile phone by DoCoMo, the continuous generation of killer chips by Intel, redesigning of the PC into the first visually appealing and zany iMac by Apple and the launch of PlayStation by Sony. The continuous launch of new-generation mobile phones by Nokia reflecting changing consumer preferences has been only too well documented. All these innovations and indeed new inventions regenerated existing markets and created new segments altogether providing that customers hope and expect for something exciting and radical at all times.

From this point of view the emphasis is moved from the introduction of specific novel and useful ideas to the general organizational processes and procedures for generating, considering and acting on such insights leading to significant organizational improvements in terms of improved or new business products, services, or internal processes. Through these varieties of viewpoints, creativity is typically seen as the basis for innovation and innovation as the successful implementation of creative ideas within an organization form this point of vies, creativity may be displayed by individuals, but innovation ours in the organizational context only.

Currency substitution and Financial Innovation

During the last decade, the financial systems of industrial countries have undergone a process of substantial transformation. Most of the changes have been the result of two events: technological progress in the area of financial services and significant changes in the regulatory environment affecting financial markets. These structural changes have coincided with an increased independence across major industrialized economics. The recent decision adopted within the European Economic Community to accelerate the process of economic integration by setting the objective of achieving  a "single market" by 1992 has prompted renewed interest in the macroeconomic effects of major changes in financial regulations coupled with an almost complete liberalized of capital movements. In particular, in a European context, some attention is being focused on the role of currency substitution in the process of financial integration, particularly on the likelihood that it might lead to increase instability of monetary aggregates and have undesirable effects on the ability of governments to conduct economic policy. The focus is placed on structural changes that affect the transactions demand for currencies. Therefore, money is motivated as an asset held only for transactions purpose, since, as a store of value; money is return-dominated by interest bearing assets. Despite the use of each currency being linked to a specific good, currency substitution is generated in this model through the interaction that the monies have in affecting the total amount of time devoted to transaction activities. The term "financial innovation" is used in this paper to encompass changes in the technological environment affecting the way individuals carry out their transactions. In particular, financial innovation – a consequence both of technical progress and of changes in financial regulations affects the time-costs involved in transacting.

A number of insights emerge from the analysis. First, because of the nature of the cash-in-advance constraints faced by individuals, financial considerations are shown to affect the effective relative prices of consumption goods. Therefore, the international transmission of the effects of financial innovation, as well as the domestic effects, depend significantly on how financial innovation alters the relative cost of using different currencies and, hence, on how it affects the equilibrium relative price of consumption goods. Second, it shown that financial innovation may lead to negative co-movement between the nominal and the real exchange rate. In particular, a country in which there is a lowering of the relative cost of using foreign currency may face a nominal appreciation and a real depreciation of its currency. The negative co-movement between the nominal and the real exchange rate in response to financial innovation has a clear interpretation in terms of monetary effects, on one hand, and real effects, on the other hand. While the response of the nominal exchange rate to financial innovation is driven by changes in the relative demand for currencies, the response o f the real exchange rate depends on how the relative "effective" price of consumption goods is affected by financial innovation. Third, cross-border transfers of seigniorage, which occur because of the presence of currency substitution, play a significant role in the international transmission of the effects of financial innovation. It is shown that a change in the regulatory environment that reduces the cost of transacting in foreign currency results in a net seigniorage inflow the rest of the world. This cross-border transfer of seigniorage has general equilibrium effects on consumption, the real exchange rate, and the demand for domestic and foreign currency.

The Indian Story: Role of Finance in Innovation

Given the fact that the Indian economy is growing at 6-8% per year, while exports are growing at 30% Cumulative Annual Growth Rate (CAGR), and many Indian firms are successfully competing against international firms and brands, it can stated that this has been made possible by a combination of factors, including enabling environment, raising capital and labor productivity as well as improved quality of goods and services at lower costs. In the growth of the Indian economy, Innovation is emerging as a key driver, although this may neither be apparent nor readily visible.

Various e-governance projects and initiatives kick started at the national level are being filtered to the state level at a quicker pace. The government can encourage and involve industry-academia consortia to show the way forward in such e-governance projects. The government's known espousal of the Open Source movement and adoption of Linux by a number of state governments and related agencies has highlighted the force-multiplier effects of IT innovation.

The National Knowledge Commission (NKC) conducted a nationwide survey among large firms, as well as small and medium enterprises to explore the role being played by innovation in fueling India's economic growth. The NKC survey reveals that Innovation Intensity (i.e. the percentage of revenue derived from products/services which are less than 3 years old) has increased for large firms as well as small and medium enterprises. The strategic prioritization of innovation as a factor critical to growth and competitiveness has also achieved significant prominence since the start of economic liberalization in India. The NKC survey further highlights crucial parameters at the firm level that have enabled some firms to be more innovative than others, including the role of structural frameworks and processes. It is expected that dissemination of the survey results across India's industrial spectrum will highlight best practices in industry and thereby also generate catalytic impact on a wider scale. Some of the key results of the survey are:

A. Increase in Growth and Innovation

* 'Innovation intensity' (i.e. the percentage of revenue derived from products/ services which are less than 3 years old) has increased for large firms and SMEs, with SMEs registering a greater increase in Innovation Intensity than large firms 42% of the large firms and 17% of the SMEs are also 'Highly Innovative' firms (i.e. firms who have introduced 'new to world' Innovations during the course of business in the last five years).

* Nearly half of the large firms and SMEs attribute more than 25% of change in the following factors to Innovation: increase in competitiveness, increase in profitability, reduction in costs and increase in market share. For large firms Innovation has the most significant impact on competitiveness, while for SMEs, Innovation has the most significant impact in increase in market share.

* 17% of the large firms rank Innovation as the top strategic priority and 75% rank it among the top 3 priorities. All the large firms in our sample agree (of which 81% strongly agree) that Innovation has gained importance as being critical to growth and competitiveness since the start of economic liberalization in India. All the large firms agree (of which nearly half strongly agree) that they cannot survive and grow without investment in Innovation. An overwhelming 96% of large firms see Innovation spending over the next 3-5 years.

B. Innovation Strategy

* Area of business: For large firms, Innovation is most highly concentrated in operations and sales and marketing.

* Factors Influencing Innovation: More than half of the increase in the market share, competitiveness, profitability and reduction in costs due to Innovation has occurred in SMEs due to three types of Innovations new products, new processes and new services. At the same time, the customer is the primary external factor that leads more than half of the large firms to innovate.

* Breakthrough and Incremental: 37.3% of large firms have introduced breakthrough Innovation, while 76.4% have introduced incremental Innovation as compared with breakthrough Innovation.

* Timeframe: The average timeframe (from idea generation to market) of Innovation projects for half of the large firms is 1-3 years. Innovation projects in manufacturing firms have longer gestation period then in services.

Which firms are Innovative?

* SMEs have greater Innovation Intensity than large firms.

* Innovation Intensity for privately and publicly owned firms is significantly higher than that of government owned firms.

* Firms with majority foreign ownership have greater Innovation Intensity than those with majority Indian ownership.

* Innovation Intensity for MNCs significantly higher than for non-MNCs while there is little difference in the percentage of 'Highly Innovative' firms among MNCs and non-MNCs.

* Internal processes for Innovation such as maintaining a specific Innovation department, allocation funds, rewarding innovative employees, forecasting probabilities of success, formalizing processes and systematic attempts, maintaining physical locations for Innovation and constituting cross-functional teams all lead to firms being more innovative. Further, firms with greater R & D spending, Innovation spending and strategic prioritization for Innovation are also more likely to be more innovative.

* Firms with their primary market in India have higher Innovation Intensity than those with primary markets abroad. On the other hand, a greater proportion of firms with their primary market abroad are Highly Innovative (i.e. have introduced more 'new to world' Innovations) as compared with firms with their primary market in India.

* Firms in industries were Innovations are patented, with more patent; lings and use of IPR consultants are more innovative.

* Firms partnering with government agencies, collaborating with universities and R & D labs also tend to be more innovative

Barriers to Innovation

1. External:

The most crucial external barrier, as perceived by both large firms and SMEs, is skill shortage due to the lack of emphasis on industrial Innovation, problem-solving, design, experimentation, etc. in the education curriculum.

Other prominent external barriers are lack of effective collaboration with research in universities and R & D institutions, excessive government regulation as well as insufficient pricing power to derive value from Innovations.

2. Internal:

The most important internal barriers as perceived by large firms are lack of organizational focus on Innovation as a strategy for growth and competitiveness; insufficient knowledge management systems within the company; and poor understanding of customer needs and market dynamics.

For SMEs, prominent internal barriers are skill shortage due to lack of effective in-house training programmes; inability to move beyond the first successful Innovation and develop a sustainable model for continuous Innovation; as well as poor understanding of customer needs and market dynamics.

Why Innovation Fail?

Innovations that fail are often potentially 'good' ideas but have been rejected or 'shelved' due to budgetary constraints, lack of skills or poor fit with current goals. Failures should be identified and screened out as early in the process as possible. Early screening avoids unsuitable ideas devouring scarce resources that are needed to progress more beneficial ones. Organizations can learn how to avoid failure when it is openly discussed and debated. The lessons learned from failure often reside longer in the organizational consciousness than lessons learned from success. While learning is important, high failure rates throughout the innovation process are wasteful and a threat to the organisation's future.

The caused of failure have been widely researched and vary considerably. Some causes will be external to the organization and beyond control. Others will be internal and ultimately within the control of the organization. Internal causes of failure can be divided into causes associated with the cultural infrastructure and causes associated with the innovation process itself. Failure in the cultural infrastructure varies between organizations but the following are common across all organizations at some stage in their life cycle (O' Sullivan, 2002);

* Poor Leadership

* Poor Organization

* Poor Communication

* Poor Empowerment

* Poor Knowledge Management

Common causes of failure within the innovation process in most organizations can be distilled into five types:

* Poor goal definition

* Poor alignment of actions to goals

* Poor participation in teams

* Poor monitoring of results

* Poor communication and access to information

Effective goal definition requires that organizations should state explicitly what their goals are in terms understandable to everyone involved in the innovation process. This often involves stating goals in a number of ways. Effective alignment of actions to goals should link explicit actions such as ideas and projects to specific goals. It also implies effective management of action portfolios. Participation in terms refers to the behavior of individuals in and of teams, and each individual should have an explicitly allocated responsibility regarding their role in goals and actions and the payment and rewards systems that link them to goal attainment. Finally, effective monitoring of results requires the monitoring of all goals, actions and terms involved in the innovation process.

Private Sector - The Road A head

Meanwhile at the corporate level, hopefully innovations are being encouraged in most of the big companies of private sector. However, it is pertinent to ask whether all these services and innovations are even applicable for the Indian market. Building products and services for customers abroad is all well and good but remember the productivity gains or the royalties all accrue to companies (customers) abroad. The Indian companies may be happy by earning a one time fee with gross margins of 20-25%. Supplying quality labor and a highly professionalized pool of engineers to the world is laudatory; there is also a need to develop a more individualized innovative culture shorn of the influence of big customers abroad. The IT industry, for instance, has reached a maturity level where the industry leadership must begin seriously thinking in terms of building products and IPRs which are saleable not just in India but anywhere in the world.

While capital spending and allocation of resources have not reached the scale of giant, global corporations, Indian companies face the challenge of creating and fostering a culture that encourages and nurtures innovation at almost all levels. Additionally, they have to contend with the influence that big, foreign customers have on the working and process cultures of their organizations.

It is the path to commercialization of actual technologies and products that the learning phase also begins and certain failures have to be accounted for. They would do well to remember that innovation requires continuous experimentation, trail and error, tinkering with and doing a number of new things, and breaking old rules. Given that Indian companies are at the first stage of real innovation and more so at the SME level currently, perhaps a collaborative meshing of people across borders and cultures can be encouraged for some time.

Conclusion

This study attempts to highlight the rising Innovation activities and awareness in India as well as the need to continuously and publicly encourage this trend as a key enabler in India's economic growth and competitiveness. However, there is need for further effort along a range of parameters in order to fully realize India's Innovation potential.

There is also need for more effective collaboration between industry, universities and R & D institutions. Systematic reform of the higher education system in India is essential to develop the required intellectual capital as well as generate effective synergies among industry, government, and the educational system, the R & D environment and the consumer. Innovation is a complex activity that requires widespread interaction across the entire economy, from the grassroots to the large firm level. It is therefore recommended that a comprehensive campaign should be initiated to address these issues and to spur efforts to make India a global leader in innovation.

References:

* Byrd, Jacqueline (2003). The Innovation Equation- Building Creativity & Risk taking in your Organization. San Francisco, CA: Jossey- Bass/Pfeiffer- Aprint. ISBN 0-7879-6250-3.

* Davila, Tony; Marc J.Epstein and Robert Shelton (2006). Making Innovation Work: How to Manage It, Measure It, and profit from It ". Upper Saddle River: Wharton School Publishing. ISBN 0131497863.

* Luecke, Richard; Ralph Kartz (2003). Managing Creativity and Innovation, Boston, Ma: Harvard Business School Press. ISBN 1591391121.

* National Knowledge Commission Report on Innovation, 2007.

* Nasscom Survey 2007.

* O'Sullivan, David (2002). "Framework for Managing Development in the Networked Organisations". Journal of Computers in Industry (Elsevier Science Publishers B.V.) 47 (1): 7788. doi: 10.1016/S0166-3615(01)00135-x.ISSN 01663615.

* http://www.fastcompany.com/blog/saabira-chaudhuri/intinerant-mind/united-states-world number one innovator.

* BIS. 1995. The Supervision of Financial Conglomerates, A Report by the Tripartite Group of Bank, Securities and Insurance Regulators, July; www.bis.org.

* Bossone, Biagio. 2000. 'What Makes Banks Special? A Study on Banking, Finance, and Economic Development'. The World Bank.

* Carlin, W. and C. Mayer. 2003. "Finance, Investment and Growth." Journal of Financial Economics , 69(1): 199-226.

* http://www.questia.com/googleScholar.qst? 
 

Mr. Birenjan Digal
Lecturer
Al-Ameen Institute of Management Studies
Bangalore-560027
 

Source: E-mail November 23, 2009

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