19 February 2015

Will digital innovation disintermediate banking — and can regulatory frameworks keep up?

Ce4TwiER_400x400Many of Europe’s economies are hampered by a waning number of innovations, partially attributable to the European financial system’s aversion to funding innovative enterprises and initiatives. Pēteris Zilgalvis discusses his recent Policy & Internet article The Need for an Innovation Principle in Regulatory Impact Assessment: The Case of Finance and Innovation in Europe (2014 6,4), which argues for the adoption of an “innovation principle” in regulatory impact assessment that prioritizes regulatory approaches that serve to promote innovation.

Many of Europe’s economies are hampered by a waning number of innovations, partially attributable to the European financial system’s aversion to funding innovative enterprises and initiatives. Image by MPD01605.

Innovation doesn’t just fall from the sky. It’s not distributed proportionately or randomly around the world or within countries, or found disproportionately where there is the least regulation, or in exact linear correlation with the percentage of GDP spent on R&D. Innovation arises in cities and countries, and perhaps most importantly of all, in the greatest proportion in ecosystems or clusters. Many of Europe’s economies are hampered by a waning number of innovations, partially attributable to the European financial system’s aversion to funding innovative enterprises and initiatives. Specifically, Europe’s innovation finance ecosystem lacks the necessary scale, plurality, and appetite for risk to drive investments in long-term initiatives aiming to produce a disruptive new technology. Such long-term investments are taking place more in the rising economies of Asia than in Europe.

While these problems could be addressed by new approaches and technologies for financing dynamism in Europe’s economies, financing of (potentially risky) innovation could also be held back by financial regulation that focuses on stability, avoiding forum shopping (i.e., looking for the most permissive regulatory environment), and preventing fraud, to the exclusion of other interests, particularly innovation and renewal. But the role of finance in enabling the development and implementation of new ideas is vital — an economy’s dynamism depends on innovative competitors challenging, and if successful, replacing complacent players in the markets.

However, newcomers obviously need capital to grow. As a reaction to the markets having priced risk too low before the financial crisis, risk is now being priced too high in Europe, starving the innovation efforts of private financing at a time when much public funding has suffered from austerity measures. Of course, complementary (non-bank) sources of finance can also help fund entrepreneurship, and without that petrol of money, the engine of the new technology economy will likely stall.

The Internet has made it possible to fund innovation in new ways like crowd funding — an innovation in finance itself — and there is no reason to think that financial institutions should be immune to disruptive innovation produced by new entrants that offer completely novel ways of saving, insuring, loaning, transferring and investing money. New approaches such as crowdfunding and other financial technology (aka “FinTech”) initiatives could provide depth and a plurality of perspectives, in order to foster innovation in financial services and in the European economy as a whole.

The time has come to integrate these financial technologies into the overall financial frameworks in a manner that does not neuter their creativity, or lower their potential to revitalize the economy. There are potential synergies with macro-prudential policies focused on mitigating systemic risk and ensuring the stability of financial systems. These platforms have great potential for cross-border lending and investment and could help to remedy the retreat of bank capital behind national borders since the financial crisis. It is time for a new perspective grounded in an “innovation-friendly” philosophy and regulatory approach to emerge.

Crowdfunding is a newcomer to the financial industry, and as such, actions (such as complex and burdensome regulatory frameworks or high levels of guaranteed compensation for losses) that could close it down or raise high barriers of entry should be avoided. Competition in the interests of the consumer and of entrepreneurs looking for funding should be encouraged. Regulators should be ready to step in if abuses do, or threaten to, arise while leaving space for new ideas around crowdfunding to gain traction rapidly, without being overburdened by regulatory requirements at an early stage.

The interests of both “financing innovation” and “innovation in the financial sector” also coincide in the FinTech entrepreneurial community. Schumpeter wrote in 1942: “[the] process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.” An economy’s dynamism depends on innovative competitors challenging, and if successful, taking the place of complacent players in the markets. Keeping with the theme of Schumpeterian creative destruction, the financial sector is one seen by banking sector analysts and commentators as being particularly ripe for disruptive innovation, given its current profits and lax competition. Technology-driven disintermediation of many financial services is on the cards, for example, in financial advice, lending, investing, trading, virtual currencies and risk management.

The UK’s Financial Conduct Authority’s regulatory dialogues with FinTech developers to provide legal clarity on the status of their new initiatives are an example of good practice , as regulation in this highly monitored sector is potentially a serious barrier to entry and new innovation. The FCA also proactively addresses enabling innovation with Project Innovate, an initiative to assist both start-ups and established businesses in implementing innovative ideas in the financial services markets through an Incubator and Innovation Hub.

By its nature, FinTech is a sector that can benefit and benefit from the EU’s Digital Single Market and make Europe a sectoral global leader in this field. In evaluating possible future FinTech regulation, we need to ensure an optimal regulatory framework and specific rules. The innovation principle I discuss in my article should be part of an approach ensuring not only that regulation is clear and proportional — so that innovators can easily comply — but also ensuring that we are ready, when justified, to adapt regulation to enable innovations. Furthermore, any regulatory approaches should be “future proofed” and should not lock in today’s existing technologies, business models or processes.

Read the full article: Zilgalvis, P. (2014) The Need for an Innovation Principle in Regulatory Impact Assessment: The Case of Finance and Innovation in Europe. Policy and Internet 6 (4) 377–392.


Pēteris Zilgalvis, J.D. is a Senior Member of St Antony’s College, University of Oxford, and an Associate of its Political Economy of Financial Markets Programme. In 2013-14 he was a Senior EU Fellow at St Antony’s. He is also currently Head of Unit for eHealth and Well Being, DG CONNECT, European Commission.


Note: This article gives the views of the authors, and not the position of the Policy and Internet Blog, nor of the Oxford Internet Institute.