BANKTHINK

The Cult of 'Innovation' Can Be Hazardous to Your Bank

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It's heartwarming for a financial inventor to see how many stars are aligned with the notion that financial innovation is praiseworthy – at least if it's judged to be "consumer-friendly," and targets the "underserved."

Remember the FDIC's stillborn program to encourage banks to make cheap loans to risky consumers? And now we have another regulator setting up special arrangements to favor the right kind of innovation—presumably, innovation targeting disadvantaged customers.

What's wrong with all that?

I'll tell you one thing that's wrong. Innovation to help the underserved is not a certified and sure good thing. Such innovation caused the recent crisis, and can trigger another. 

Think again before you decide to innovate—not because you could blow a bubble, but because you could blow your capital.

The payment option mortgage was an innovation. Then there was the stated-income mortgage. And innovative mortgages with loan-to-value ratios up to 115% or 125%. 

Making these loans, institutions went broke. 

The FHA was no slouch at innovation: until late 2007, it even made it possible for home purchasers to avoid entirely its minuscule 3.5% down payment requirement, so that they had no skin in the game.  That program continues to contribute to the FHA's deficit.

These were unsound, unjustifiable, dangerous innovations. But they carried the flag of the "underserved," to whom they offered amazing financial opportunities. No regulator had the nerve to object to banks making housing more "affordable." An incredible track record of long-continued gross negligence.

The deadly impact of these innovations was multiplied by wholesale-market innovations, such as mortgage-backed securities. Then there were SIVs, auction-rate securities, CDOs, and let's not forget the incredible proliferation of CDS's. Off-balance-sheet trickery multiplied risk.   

But the latter was secondary. Producing bad mortgages, mortgages that wouldn't be paid, innovative mortgages, was the primary driver of the housing price bubble, which precipitated the "Great Recession."

In the past, banks sometimes innovated by offering higher and unprofitable interest rates on deposits and by delivering more cash value to depositors in other ways. Likewise "consumer-friendly," right?

Bouncing off the ropes  after the latest crisis, we've spawned illustrious nonprofits, contests and trade shows targeting consumer-friendly innovation—with standards of verity stretched even further. For instance, anything  that causes people to save is considered  angelic.  But, will increased savings favor economic growth—or stagnation?  

Anything that leads the underserved to borrow more affordably is also said to constitute the desirable kind of innovation. But, is this borrowing salutary—even for those who probably can pay it back? We want the same group to save more … and also borrow more? 

Wells Fargo, JPMorgan Chase and U.S. Bank are among the most successful of the mega institutions. Each owes little of its success to innovation.

Wells didn't "innovate" to achieve its 30%-plus share of the mortgage origination market.

Does Chase's offering credit card customers a 5% discount at Kohls constitute innovation? Its recent breakthrough in offering plastic cards in real time at branches was not an innovation. The prepaid companies had long been selling Visa cards off the shelf.  

Even before our enlightened era of Chief Risk Officers, institutions had already begun designating Chief Innovation Officers. What a relief to the thousands of other managers thus let off the hook! They could now focus on running the business, a nontrivial pursuit. Let the Innovation Department worry about innovation.

And "innovation" now refers, with laser focus, precisely to the trendy. So, a large part of bank "innovation" focuses on mobile—of unknown, but very likely negative, profitability. 

How can we instead innovate profitably, not imitatively or randomly, with less risk, less delay, and less crowding?

By identifying the sources of value, the deliverables, for which large, addressable segments of consumers will choose to pay—whether these come under the rubric of convenience, protection, savings or rewards.

Banks have renamed "market research" as "customer insights." That's clever, because "market research" was frequently discredited, therefore,  change the name without changing the substance. But the worthwhile customer insights relate to customers' actual willingness to pay for honestly promoted benefits. 

For many customers, it's worth more to get a card immediately, without risk of a turndown. It's worth more to be able to use a single account, which can have either a credit or a borrowed balance, for all forms of payment.

But the great majority of innovations fail or generate disproportionate risk, often because they don't produce benefits for which customers gladly pay. You can live and prosper without that.

Andrew Kahr is a principal in Credit Builders LLC, a financial product development company, and was the founding chief executive of First Deposit, later known as Providian.

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Comments (4)
Banks seem to break down into 3 buckets: Innovators, Fast/slow followers, tried & true.

Best of class banks: 1) Aware, study current innovation/profitability from competitors
2) Build outlines/pro formas/budgets on the current "innovations".

"Slow followers" like to say that they're deliberate and save time, money,
and learn from competitors. C suite likes the slow or fast follower disciplined mantra.
Posted by frankward | Tuesday, December 11 2012 at 11:34AM ET
The driver of bad lending was outlandish profits on the investment banking side, which were distributed primarily to investment bankers. It is pointless to blame consumers for the faults of slovenly lending practices. The writer doesn't blame innovation on the investment banking side, but that's the kind of innovation that kills economies.
Posted by masaccio | Tuesday, December 11 2012 at 11:58AM ET
Mr. Kahr confuses innovation based upon market research, economics, financial analysis, longitudinal testing, stress testing and prudence with guessing.
Posted by Pegasus Intellectual Capital Solutions | Tuesday, December 11 2012 at 12:22PM ET
Agree with Gus; There's innovation, and there is information. Innovation itself is never a bad thing, but if innovation obscures information-- like it did in the financial crisis when the banking sector got so excited about mortgage backed securities that they forgot to do their homework, then it can be dangerous. I'm afraid of buzz words, not buzz.
Posted by mfriedrichs | Tuesday, December 11 2012 at 1:45PM ET
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