HOW WESTERN BANKING FINANCIAL INNOVATION CAN IMPORVE THE PERFORMANCE OF DEVELOPMENT CREDIT BANK LTD (INDIA)
CHAPTER - I
Performance measure quantitatively and qualitatively tell us something about organisation's products, services and the processes that produce them. Performance measures describe how well the organisation are perfoming, does the organisation meet their goals, customers are satisfied and where improvements are necessary. The efficiency in a banking institution is considered as a major issue in new monetary and financial environment. The competitiveness and efficiency of financial institutions is not easy to measure, since their product and services are intangible in nature. There are many studies been put forward to measure the productivity and efficiency of the banking industry using output, cost, efficiency and performance.
Performance measurement is a fundamental building block of Total Quality Measurement and a total quality in the organization. In past organizations have always measured performance in some way by financial performance, this traditional performance measure, based on cost accounting information, provide little to support to the organizations because they do not show the process performance and improvements seen by the customers. In a successful total quality organization, performance will be measured by the improvements seen by the customer as well as by the results delivered to other stakeholders, such as the shareholders.
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In my dissertation I will do research on how western banking financial innovation can improve the performance of DEVELOPMENT CREDIT BANK LTD (INDIA). Financial innovation can be described as ‘design of any new financial products or securities'. Financial innovation will include the new financial products, advanced technology and services offered to the prospective and existing customers. Development Credit Bank LTD (DCB) will be improving their performance by implementing such new and creative financial innovations.
Due to recent global financial crisis, majority of financial sectors all over the world has been affected. The recent credit crisis in U.S had shaken the financial markets, let down the confidence of consumer and investors and is threatening to the economies around the world. Ever since the financial crisis began banks had mounted heavy losses up to $500 billion dollars and assets write down.
The year 2008-09 will go down in history as one in which the world economy received an unprecedented shock owing to the melt down of the financial system in the USA and in Europe.
Indian banks and financial sectors are well controlled by Reserve Bank of India (RBI). Due to which they were less prone to be caught by prevailing attitude in the financial system of the world. Indian banks are well capitalised and the Indian economy remains with the steady growth. On the other hand no doubts Indian economy also severely affected by destruction of demand caused by the extraordinary financial crisis that began in the year 2008.
At a world level, in recent few months, there are a few positive signals. However, these signals are not strong enough to point to a firm turnaround. In India as well there are some signs of recovery and improvement. Nevertheless, it may be a while before the economy picks up the required momentum.
As we have seen so far that, now global economies are started towards upward and world economies comes up from global recession. Therefore all the economy and the organisation will look after there performance of the business, target population and try to achieve their strategies and goal. Therefore performance management and performance measurement will play an important role in the organisation.
1.1: PERFORMANCE MANAGEMENT:
Performance Management is known as the “Achilles' Heel” of human capital management, and it is the most difficult HR system to implement in organisations.
In fact, performance management is consistently one of the lowest, if not the lowest, rated area in employee satisfaction surveys. Yet, performance management is the key process through which work gets done. It's how organisations communicate expectation and drive behaviour to achieve important goals; it's also how organisation identifies ineffective performers for development programs or other personnel actions.
It is the key factor in successful implementation of company's strategies and techniques in pursuit of its goal and ensuring success of business organisation both in long term and short term. Different economic decisions are taken on the basis of the organisation performance. A need of a sound system of performance measurement is necessary for Financial Institutions as these are the institutions which are run by public money and they form a backbone of a country's economy, their accountability is of more important than a general trading company. So special attention is required to be given to this aspect of financial institution
Always on Time
Marked to Standard
The short-term financial performance can seen directly through increase in Earning per share, profitability etc. But in long term there are certain intangible which are effective and are much more important for the stability and sustainability in the current competitive and financial crisis these are quality service, use of Advance technology for employees and customers satisfaction etc.
INTRODUCTION ABOUT DEVELOPMENT CREDIT BANK LTD (DCB, INDIA).
A new generation private sector bank, Development Credit Bank (DCB) is the preferred banking services provider across 80 state-of-the-art branches across 10 states and two union territories. The Bank has recently launched several value added initiatives and intends to become one of the country's preferred and profitable private sector banks, providing a comprehensive suite of “best in class” products for customers in Retail, small and medium enterprise (SME) and Corporate Banking market segments in chosen geographies.
DCB has deep roots in India since its inception in 1930. Its promoter the Aga Khan Fund for Economic Development (AKFED) holds over 24% stake. AKFED is an international development agency dedicated to promoting entrepreneurship and building economically sound enterprises in the developing world. It had co-promoted HDFC in India in the late seventies. AKFED operates as a network of affiliates comprising 90 separate project companies. Employing over 30,000 people, it reported annual revenues in excess of US$1.5 billion. The Fund is active in 16 countries in the developing world.
A HISTORICAL PROSPECTIVE:
DCB has wide Network of 80 state-of-the-arts, customer friendly, and conveniently located branches spread across the states of Maharashtra, Gujarat, Andhra Pradesh, Karnataka, New Delhi, Rajasthan, Goa, Tamil Nadu, Haryana, West Bengal, Union Territories of Daman & Diu and Dadra & Nagar Haveli. Currently DCB has dedicated staff of over 1800.
1.2: PERFORMANCE MEASUREMENT:
A simple performance measurement framework is outlined, which includes more than just measuring, but also defining and understanding metrics, collecting and analysing data, then prioritising and taking improvement actions. A description of the balanced scorecard approach is also covered. A good performance measurement framework will focus on the customer and measure the right things. Performance measures must be:
• Meaningful, unambiguous and widely understood
• Owned and managed by the teams within the organisation
• Based on a high level of data integrity
• Such that data collection is embedded within the normal procedures
• Able to drive improvement
• Linked to critical goals and key drivers of the organisation
There are four key steps in a performance measurement framework - the strategic objectives of the organisation are converted into desired standards of performance, metrics are developed to compare the desired performance with the actual achieved standards, gaps are identified, and improvement actions initiated.
Performance measurement can be broadly divided into two parts
1) Financial Performance Measurement
2) Non-Financial Performance Measurements
1) Financial Performance Measurement:
Financial Measurement provides various techniques for measuring financial performance of a business, out of them one is Financial Ratio Analysis. Bank regulator and Bank financial analyst use this technique to measure a bank performance. Financial Performance Measurement is also important as it measures the actual performance of a company or institution in terms of money. The improvement in financial performance will lead the bank in smooth functioning of its activities, increase investors and customers' confidence in the bank and the employees' turnover morally will be less.
2) Non-Financial Performance Measurement:
Non-financial performance offers some advantages over performance measurement based on financial data. It is a closer link to organizational long term strategy. Financial measurement system measures organizational performance based on accounting yardstick they do not measure progress made relating with customers requirement or challenges by the competitors. They are important in achieving company's profitability maintaining competitive strength and achieving organisations long term objectives.
As we have seen the basic and introduction part about the performance measurement. In my dissertation I will discuss the performance measurement in detail in further chapters in context with Development Credit Bank Ltd (DCB) and Hong Kong and Shanghai Banking Corporation (HSBC).
1.3: PURPOSE OF THE RESEARCH:
Generally we know that any outcome of the performance measurement, describe the overall performance of the organisation. My topic mainly focuses on the performance improvements of an Indian Bank, i.e. how Development Credit Bank Ltd (India) can improve their performance by adopting western financial innovations, from western banking.
MAIN PURPOSE OF THE RESEARCH:
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Development Credit Bank Ltd has a vision “to be the gold standard in customer service in Indian Banking” and its mission is “to be the preferred financial service provider amongst the Bank's peers with a passion for excellence in service.” In fulfilment of their vision and mission I would like to help them to find where they are lagging behind against their competitors like HDFC Bank, ICICI Bank and Axis Bank.
The main purpose of the research in terms of performance is to be measure and analyse the current performance of Development Credit Bank Ltd. For the financial year 2008-09 and it will compare with its competitors. The technique which I will follow is “Benchmarking”. In chapter III, research technique and method I will discuss Benchmarking in detail.
The initial parts of my finding will depend on the secondary data which is published by banks. In chapter IV, result and analyse I will calculate the following ratios of Development Credit Bank Ltd and compare them with HDFC Bank and ICICI Bank.
1. ROA (Return on Assets),
2. ROI (Return on Investment),
3. ROCE (Return of Capital Employed),
4. Total Deposits, Loan Deposits,
5. Total Assets,
6. Level of Assets to Equity,
7. Loans and Advance to customers and
8. Impairment of Assets and Losses.
Therefore measuring the performance of Development Credit Bank Ltd and comparing them with other banks is to identify the weakness of its performance in different areas of its business operations and identify their position in the market which is currently very competitive.
The second part of the dissertation is most important part of my research. In second part I will mainly focus on the western banking financial innovation and the products and services which are offered by Development Credit Bank Ltd (India) and the HSBC Bank (UK). I will try to compare the products and services which are offered by UK's leading bank HSBC Bank and the Indian Bank Development Credit Bank Ltd. In this part I will discuss the need and requirement of Indian customers and the staff of Development Credit Bank Ltd. I will also focus on the technology gap between HSBC Bank and Development Credit Bank Ltd.
The research method and technique based on primary data collection, which is conduct by me during past two months. The result and outcome of this finding will be include in the chapter -VI i.e. recommendation and conclusion. This primary research will help to Development Credit Bank Ltd to increase the overall performance of the Bank. It will also help to achieve their vision and mission of the organisation.
1.4: OBJECTIVES OF THE RESEARCH:
In order to the aim for which this research is being undertaken, following objectives need to be accomplished which will lead to provide us the clear view how effective and proper performance management system will help management to achieve the goals of Development Credit Bank LTD in the dynamic business environment
The research objectives are as follows:
1) To find the role of Performance measurement, Feedback system and Personal Development plan in achieving organizational and individuals goals.
2) To analyze the benefit of introduction of western banking financial innovations to increase the financial profit of the Bank and challenge the competition.
3) To analyze the current customer service problem and benefits of introduction of new technology (Automated Machines for deposits) in all branches to reduce customer serving time.
4) To conduct a primary research based on telephone interviews, questionnaires and observation in order to come up with innovative ideas to improve performance.
5) To introduce new measures to improve the overall service quality.
6) To identify the impact of new financial innovation on the bank for measuring performance
1.5: LIMITATION OF THE RESEARCH:
The research design section has described the pros and cons of every technique adapted from sampling to focus groups, however utmost care will be taken place to minimize the impact. Other limitations which I may come across with my dissertation are:
1) Time Limit:
The main important thing is the time allocated for the research as a research and analysis of the banking sector requires lots of attention and time factor. So time is one of the biggest constraints in the research. I have only three months to conduct this research; I need to try my best to solve the above research problem.
2) Lack of Access:
It may be difficult to obtain appropriate financial and non-financial information of the bank due to limitation of the access.
3) Confidential Information:
It may not be possible for all the staff to disclose confidential information of the bank to me. I need to go through the published financial statements and company info myself.
4) Various assumptions:
For analyzing the Performance of the bank I will be using various different Accounting and Financial ratios and Annual Reports, which is published by the bank. But this Financial Ratios requires lots of assumptions and all the banks do not have the same strategy and operations.
5) Difficult to summaries:
It may be very difficult to summaries the whole data which runs through several months and several years in a few cases.
6) Lack of Cooperation:
Sometimes it may very difficult to get cooperation from staff or customers while conducting research. Sometimes the bank personnel or customers are very busy so they did not reply to my questions in detail.
The research methodology for this study will be done by using secondary data only. These are data that are easily available from various sources, for example, paper - based sources such as books, journals, periodicals, abstracts, indexes, directories, research reports, conference papers, market reports, annual reports, internal records of organizations, newspapers, and magazines and secondly, electronic sources such as CD-ROMs, on-line databases, Internet, videos and broadcasts. (Cooper, 2005)
Therefore, this study will use secondary data sources like annual reports of the companies for calculating different categories of financial ratios for the analysis of the Development Credit Bank Ltd.
CHAPTER - II :
This chapter will review all existing literature related to the performance measurement and financial innovation of banks. It will also review the contributions other researchers have made to the concepts of the impact of the Performance measurement and financial innovation on banking industry.
Generally the performance of a bank and financial institution has been measured with ratio analysis, comparing the values of financial statement with other financial institutions, by comparing the financial statements with the budget, or by bench marking, balance scorecard etc. In my research the performance of Development Credit Bank Ltd is measured with use of various ratios and comparing with its competitors in India, such as HDFC Bank and ICICI Bank.
2.1: Literature Review of Performance Measurement
Review of Management Literature shows that the research in services is so far lower than that of manufacturing industry.
Performance Measurement is a key factor in ensuring the successful implementation of company's strategies and techniques in pursuits of its goals and in ensuring the success of the organisation in both the terms short term and the long term.
The service classification scheme of Fitzgerald (1991) is one of the most often cited studies of Performance measurement in Services. They identified six dimensions of performance and three service delivery process types which primarily affect how to measure performance as well as costing systems for e.g. the choice of measurement mechanism will be determined by service process type but Fitzgerald's study does not concern non-financial Performance in the finance industry. In recent years non-financial performance have received considerable attention from Management Scholars and there are various studies put forward to deal with non-financial performance measures such studies includes the study of Fitzgerald (1991), Ballantine (1998), Evans (1997)
SPATHIS and DOUMPOS, (2002) investigated the efficiency of the Greek banks according to their assets range. They used dual criteria method to categorize Greek banks according to the return and operation factors, and grade accordingly small banks and large banks.
LEVINSON H. (2005) an entire linkage of sequence of performance measurement stating that for e.g. employee morale increases customer satisfaction and this in turn returns higher return on capital and argued that employee morale is a necessary ingredient for achieving higher financial return in long term because such employees produce satisfied and loyal customers and such customers drive financial performance of the company.
Again there are various theories about the performance measurement of banking and financial institutions. Pulakos, E.D., Hanson, R.M., & O'leary, R.D. (2008) uses interest margin as a performance measurement of U.S commercial banks. He defines interest margin as the difference between interest income and expense divided by total assets.
(Kyriaki Kosmidou, and Constantin Zopounidis, 2008) in their studies of Measurement of Bank Performance in Greece. They had measured the financial performance of commercial banks and cooperative banks of Greece using same and different financial ratios for each type of banks.
They had selected 11 financial ratios for each type of bank commercial and cooperative. E.g. of such ratio are Loans/Total Assets, Return On Equity, Return on Assets, Equity/Deposits, Equity / Total assets etc. They had stated the reason for using different ratios for each type of bank because the banking legislation of commercial banks is different than those of cooperative banks.
They had used Promethee methodology to evaluate the performance of commercial and cooperative banks in Greece with the aid of specific financial ratios. (The Promethee method is the extension to the camel rating system, which is widely used in the assessment of banks performance) The output of the ratio analysis was used in Promethee method to rate the banks accordingly.
The advantage of Promethee method is that it does not assume a linear evaluation model and it can easily be used with qualitative data. They had found that commercial banks are tending to increase their accounts, to attract more customers and ameliorate their financial indices, thereby becoming more competitive and maximizing their profits. They had found that commercial banks are becoming more and more competitive by making their performance better and hedge their financial risk in order to be more competitive among the European banking institutions.
(Mostaque Hussain, A. Gunasekaran and Mazhar Islam, 2002) In their study of Implications of non-financial performance measures of Finnish banks. They had found in their study that financial performance measurement is a regular and essential practice of many banks and financial institutions in Finland but measurement of non-financial performance is of less importance and not in practice on a regular basis.
In their study they observed that benchmarking is the most widely used Performance Management techniques in Finnish banks. Many banks measures financial and non-financial performance through the process of benchmarking with the other similar kind of organisation, They had find that many banks in Finland and considering customer satisfaction has a direct impact on improving financial performance and they are therefore very much aware of it. They second most important aspect is quality service in Finnish Banks and financial institutions Three Finnish banks consider quality aspects to be important. Commitment to clients and stakeholders and on-time service is the third most important aspect of non-financial performance of Finnish banks.
They had concluded that Non-financial performance differs according to the objectives and strategy of the business and can also change with different micro and macro environments. The measurement of Non-financial performance is to assure profit and to gain competitive advantage in the current competitive environment. The banking and financial institutions measures non-financial performance in order to assure profit and therefore they are been called as “profit driven” Non-financial performance measures.
(K K Purohit, B C Mazumder, Nov 2006). In their research on Performance Measurement of Banks: An application of Balance Scorecard. They had found that the performance measurement of bank under traditional measures including CAMEL rating techniques covers only the financial ratios i.e. quantitative factors, but under Balance Scorecard techniques it covers both quantitative (Financial Ratios) and qualitative (customer, internal business and innovations and learning aspects). The non financial performance measurement such as customer satisfaction, employee development and satisfaction, fund management etc are equally important with the financial activities to measure the performance of the bank.
A brief introduction to Balance Score Card technique: (Robert S. Kaplan and David P Norton, 1992) they started began to publicizing the balance scorecard through a series of Journal articles. In 1996 they had published a book called “The Balance Scorecard” Implementing Balanced Scorecards typically includes 4 processes:
1. Translating the vision into operational goals
2. Communicating the vision and link it to individual performance.
3. Business planning and index setting.
4. Feedback and learning, and adjusting the strategy accordingly.
Balance Score Card is a framework and can be characterized as a strategic management system that claims to incorporate all quantitative and abstract measures of true importance to the enterprise. Balance Score Card provides managers with the instrumentation they need to navigate to the future competitive success.
They found that the concept of CAMEL rating for performance evaluation of bank can be widened by incorporating the long-term perspective of performance evaluation of Balance Score Card which will provide a broader view of performance of a financial institution like bank.
(Mostaque Hussain and Zahirul Hoque, 2002) in their journal of “Understanding Non Financial Performance of Japanese banks” A new institutional Sociology (NIS) perspective.
They had studies the performance measurement system of four Japanese banks which were too important for the growth of their economy. They had used the new institutional sociology (NIS) framework to examine the phenomena being studied. They had put into emphasis the previously neglected institutional and organisational factors, especially economic constraints, competitions, organisational characteristics, strategy, professionals competence etc and studied the insight of new institutional sociology. Their case study suggests that economic conditions increases management's attention to improvement and measurement of Non financial performance. They had stated that economic conditions decides the bank what to perform for e.g. economic recession in Japan in late 80's and early 90's and forced bank to be strict on loans and reduce the amount of bad debts, in such cases it is the pressure on management to concentrate on its Financial performance measurement more rather than non-financial performance.
Their finding suggest that the more competitive the environment is the greater the sentiment of “business-mindedness”. This would increase accelerate organizational awareness of Non Financial Performance like customer satisfaction, quality etc
Their case study suggest that the type of financial institutions also influence the level of Non financial performance adoption they had find out that ordinary city banks are concerned more about providing quality customer service and customer satisfaction in the competitive market whereas the cooperative banks are concern more about commitment made to the ordinary customers 
(Mosad Zineldin, 2005) In his research on, Quality and Customer service Management (CRM) as competitive strategy in the Swedish banking industry.
Mosad Zineldin had made a research on Swedish banking industry in order to find out the better understanding of the relationship between customer relationship, quality customer service and bank strategic competitive positioning. He stated that competitive positioning can be achieved by quality product and services, Customer Relationship management differentiation.
High product service quality maintains the existing customer over a longer period of time and attracts new customers and business. He found that competitiveness enables banks to provide high quality Product service with a reasonable cost relative to the competitors. Evidence suggest that quality efficiency creates a profit margin and allows the banks to create a competitive edge and which in turn help the bank to increase its market share and which in turns leads to higher profitability and scale economies.
Thus he concluded that Customer Relationship Management, High quality attributes of the Product and Service and differentiations are thus important factors in creating a unique position for the bank in the minds of the target customers.
(Brown, Swarts 1989) They proposed that the banking success is usually depends upon the customers perceptions and preferences of service quality. Analysing markets based on customer perceptions, designing a service delivery system that meets customer's needs, and enhancing levels of service performance are pertinent objectives for banks to gain and retain a competitive advantage. Service quality in the broader context had received much attention because of its relationship with costs, financial performance, customer satisfaction and customer retention
SERVICE QUALITY MEASUREMENT
Quality service has become an important and essential factor for the growth and survival of the banking industry. It has also become an important research topic because it is directly and indirectly linked with the non-financial and financial performance of the bank.
Parasuraman (1988, 1994) had a developed a technique called SERVQUAL (Service Quality) for measuring the customers perception of service quality. Since the first time introduction of SERVQUAL there has been several studies put forward such as SERVPERF (Service Performance) by (Cronin and Taylor, 1992) since after its first introduction of SERVQUAL there has been several shortcomings which were as a challenged to Parasuraman. His further research on the topic (1994) provides the merits and demerits of its research.
SERVQUAL (Parasuraman, 1988) is based on the conceptualisation of service quality as the difference between customers' expectations and perceived performances. In other words, the assessment of service quality is conceptualised as a gap between what the customer expects from a class of service providers and their evaluations of the performance of a particular service provider within that class. Service quality is presented as a multi- dimensional construct which is measured by SERVQUAL along the five key dimensions
4. Assurance; and
SERVQUAL has 22 pairs of Likert- type scales with the first 22 items designed to reflect customer expectations of service for a particular industry and the second 22 to indicate the customers' perceptions of the service provided by a particular organisation, the measurement is operationalised by subtracting customers' expectation scores from their perception scores on the 22 items. The SERVQUAL instrument has been used productively for measuring service quality and has generated considerable interest in service quality measurement. However, it has also raised questions about the need to measure expectations, the interpretation and operationalisation of expectations, the reliability and validity of SERVQUAL's difference-score formulation, and SERVQUAL's dimensionality (Parasuramanet al, 1994).
(Mohammad Al-Hawari and Tony Ward, 2006) In their research on “The effect of automated service quality on Australian banks financial performance and the mediating role of customer satisfaction”
They had done research and concluded that Automated banking technology helps in providing quality customer service and which is reflected on the financial performance of the bank. Customer satisfaction can thus be considered as a key construct to bank financial performance. They had find that implementation of high quality automated service should be implemented by the bank in order to increase customer satisfaction and which lead to improve financial performance. They had found that internet service quality had no significant relationship with the customer satisfaction; improvement in the quality aspects of this dimension could enhance overall satisfaction and thus financial performance.
They found out that the availability of information on the websites (content), accuracy of online transactions, ease of use, provision of updated information (timeliness) attractiveness of bank web sites and security are not the only attributes that influence customer satisfaction. Accordingly, it is necessary for bank - marketing strategists to find the other attributes that customer use to judge service quality such as navigational and visual characteristics, providing customers what they want on time, helping customers through other ways by the method of web-links and other aspects which would really increase the level of quality internet banking service by doing this the customer will enjoy the two way communication, they will participate , learn and act immediately and will be very helpful in providing ease while incurring transactions.
2.2: Literature Review of Financial Innovation:
The literature review has been conducted to provide an insight about the financial innovation occurring in the market. Though the focus was not on the banking sector, still this literature review contains the much detail of banking sector.
The business of commercial banking has been changing rapidly and shows a drastic change as compared to 27 years ago. These changes are generally because of technical innovation and change in customer preferences. The main technical innovation has occurred in the field of telecommunication, information security and technology. Due to which financial theory and customer delivery practices has upgraded many folds and successfully brought a big transformation in the customer relationship. The earlier customer relationship focus mediators are converted into operations of risk management in data intensive field. Also, many businesses in the field of commercial banking have now able to work as global financial companies by using financial innovations. This technical innovation has equipped them with variety if financial product offering to customer. Specifically, the bank products and process of service delivery has changed because of changes in associated technology. Like, the extent to which statistics can be used cost effectively using computer and software technology with engaging the financial intermediation.
The applications of Retail Loan are now evaluated via credit scoring techniques on daily basis. Earlier this was done by using human judgment process which has inevitable human errors. Additionally, this new process provides transparency and therefore attracts other secondary markets of retail credits like credit card, mortgages etc. The risk measuring tools based on statistics can also be used to assess and control other credit risk. These tools can also be used for interest rate risks on continuous basis for all sorts of portfolios. The risk based capital allocation can be determined by using value-at-risk tool or similar tools. This is crucial for highly managed trading portfolios.
In order to understand the topic better, it is good to discuss the role of financial innovation and try to identify the key milestones and parameter for the same.
Role of Financial Innovation
As briefly indicated above, the main objective of financial system is smoothly run the deployment and utilisation of economic resources. The utilisation should be in terms of space and time when the environment is uncertain. This system also includes the payments paradigm with minimum exchange like the resource transfer from saving customers to borrowing customers. This should be done by achieving smooth consumption and high risk mitigation via diversification and insurance.
The financial system has operations subjected to cost of resources like capital, infrastructure and man power. This operations are conducted by Financial Mediators and facilitators like commercial bank, brokers etc. Most of the operations resources are spend in analysis and data collection to draw as clear picture as possible of financial market. This is done to tackle with the problems of asymmetric data and also to predict the uncertainty and risks of future in order to achieve cost effectiveness. This process gives birth to new financial products and welcomed by the consumers as the generation of these products are because of their real need. Hence, it is not wrong to define the financial innovation as means to achieve cost reduction, risk mitigation, quality and secure delivery. The financial statistics for decision making and customer satisfaction are also part of the objective of financial innovations.
These financial innovations can be introduced in market by mainly four ways; new products (mortgages), new services (Mobile banking), improved production operation (credit scoring) and new organisational structure (Internet only banks). The significance of financial innovation is decided by its contribution in economic growth and finance centrality. Since financial sector is connected with all production operation and many consumption operations, the real improvement in financial operations will impact the whole economy. Consequently, improved financial operations encourage high investment and saving with more accurate investment decisions. These factors are the indirect outcomes of finance improvement and further enhance its value by contributing in economic growth.
The importance of financial innovation is discussed in numerous articles. It is also important to understand the market scenarios which support the financial innovation. The literature survey of economic innovation has discovered the following parameter which drives the financial innovation stream:
Ø Organisation's market power
Ø Organisation Size
Ø Scope of technology improvement
Ø Suitability of financial innovation
Ø Market demand for new products
After a financial environment change, it is expected to have a wave of financial innovations which creates a fresh equilibrium along with new financial market conditions. In last 27 years, every parameter mentioned above was significantly changed and created enormous changes to the industry of commercial banking.
During the literature survey, it was found that there is a lack of experimental studies to test the hypothesis in regard of financial innovation. Specifically, it is true for those hypotheses which focus on the structural conditions that encourage financial innovation. Very few experimental studies were conducted which inclined to focus on the users characteristics of innovation, or on cross functional basis, or in regard of innovation diffusion in the market.
While doing the literature survey, we have found that more experimental studies have appeared but still the large area of study id untouched. And the need to conduct this sort of experimental studies is not only important but also very crucial for upcoming financial innovations.
This section consist the literature survey findings about the key financial innovation appeared in last 27 years. This section also covers the factors driven by the technological changes. Our discussion and finding is centred along the four categories, discussed earlier in the section 2.2: new products, new services, improved production operations and new organisational structure.
One product has experienced a tremendous change out of the several products. The mortgage loans have changed a lot over the last 27 years in United Kingdom and even in global market. 27 years ago, long term completely amortised fixed rate mortgages were used. At that time, the offering of this product was done by very few organisations. Furthermore, the prerequisite to get these loans are enormous down-payments with an excellent credit history. And the collected equity was comparatively illiquid.
These prerequisites have remarkably changed. The first significant change was in early eighties when several types of adjustable-rate mortgages were widely introduced. Previously these types of mortgages products were barred by federal regulators. In 1986, Tax Reform Act was introduced to end the income tax deductions from the consumers of non-mortgage debt. This resulted in hike of home equity lending.
The technological change responsible for the innovation of new mortgage product also contributes in the market up-trend. The new product was subprime lending. This product was initially based on the utilisation of statistical information for better assessment and pricing based on risk and uncertainty. The objective was to compensate and control the investments from higher risks. After implementation and usage the product faced major crisis and revealed several important shortcomings in the existing model of statistical measurement.
Subprime Mortgages or subprime mortgage lending is widely described related to borrowers with history of poor credit, high leverage and loan to value. The credit history is measured by FICO score, FICO score less than 620 means a poor credit history. The market of subprime mortgages rapidly grew in the UK during the initial decade of 21st century. The average was reported near to 21% of the resident mortgages. In the year end of 2007, the outstanding of subprime mortgages was approximately £500 billion, reduced from over £700 billion last year.
Subprime mortgage product acted well to enhance the number of new home owners and created the record breaking homeownership rate of 65%. This result was produced in adverse conditions when housing affordability was declining in most of the areas.
At the same time, subprime mortgage product has few disadvantages like comparatively higher interest rates and penalty in prepayment situation. Generally, the subprime mortgage is consumed by lower income and/or minority household. Hence this lending product can be predatory for the majority of its consumers. These factors led to public discussion at large scale to argue on the social costs and benefits of subprime mortgages. The way in which this product was financed and marketed was also come under question.
Also the serious spill over effects of this product on global credit market crisis emerged serious question on the dependence of financial markets and statistical information. The statistical information in question includes the option of historical time period for calibration. This dependency was in the context of risk assessment and management, creation of financial products having highly complex structure. This represents the examples of important innovation of financial process for commercial banking industry in near times.
Before this crisis, few researches were conducted to explain the efficiency and existence of the market of subprime mortgage. Zorn and Raca (2004) have characterized subprime borrowers and found that they are most likely had the poor credit history, lower incomes and less education. Also most of them belonged to minority group. Few other research papers provide several similar facts about borrowers of subprime mortgages loans like their credit history, lower incomes, and prepayment penalties and less education. Macdonald and Chinloy (2005) describe the way subprime market assists to fulfil the schedule of credit supply and how they enhance welfare in society. Yezer et al elaborates why and how subprime and prime mortgages market difference and discontinuous in nature, while other similar papers touches the topic of geographical distribution of subprime borrowers and the cases of prepayment penalties. Lastly, there are several papers studied that how lending laws (specifically predatory ones) applied locally can impact subprime mortgage and the flow of credit supply.
Another perception of research conducted about the termination of subprime mortgage by combining assessing experimental prepayment models. Other related papers have touched to elaborate the dependency and period of time between delinquencies.
From the beginning of the crisis of subprime mortgage, few researches have tried to detect various root cause problems. Pence and Mayer (forthcoming) present a general idea about the attributes of subprime mortgages which are outstanding in the current period of time and examined the reasons of substantial increase of delinquencies. These authors and few others have pointed towards a significant increment in borrower leverage in mid-2000 era. They performed measurement by combining CLTV (loan-to-value) ratios which was immeditealy trailed by falling prices of houses.
Loan-to-value is very important as theory in economics tells that borrowers will not be defaulted if they have positive home equity. Therefore, for a mortgage to be defaulted it is necessary for a borrower to have negative equity. Negative equity means owing a home in more than it's worth money. When UK house prices were declining in most of the areas and the counting of homeowners were increasing, they found themselves in negative equity situation for their homes. Many borrowers faced negative equity were shocked, especially borrowers who were using subprime mortgages and finally they were defaulted on their mortgages.
Some of the papers have paid attention towards the evolution of underwriting standards used in subprime mortgage. Particularly the focus was on the declined underwriting standards which confirmed by assessing observable characteristics and increased errors in forecasting. These errors were very common in models of empirical default. Mukherjee and Seru (2008) searched unobserved facts about negative characteristics which were correlated with the usage securitisation and characteristic this to careless screening by the originators of subprime mortgages. The main reason of declined underwriting standards was the substantial increase in the houses prices in the time period, which almost hide all the weakness.
Recently, innovations in services area are related to increased account access and improved methods of payments. Each innovation in the relevant field was designed to meet the consumer demands to provide convenient ways. This was done by providing facilities like Automated Teller Machines (ATM), introduced in the 70s and rapidly spread throughout the UK. This increased the online access of retail bank and ultimately enhanced the customer value by offering around the clock access to funds. The next financial innovation was debit cards which replaced ATM altogether in the time period of next decade. These debit cards included all the facilities provided by ATM cards and additionally they provided the facility of market payments at the point of sale from debit card holder's bank account only. In the last decade, the migration of remote access has taken place from telephone to computers and now to mobile phones. The Online banking has improved many folds, now they allow customer to access and control their accounts, and uses electronic bill payment to originate payments. The prepaid cards and stored value are also become popular and are almost everywhere in the usage.
Debit cards replaced the ATM cards completely now and provides more freedom to their users. They are essential instruments for “pay now” connected to cardholder account and offers an instant transaction which can via PIN based online methods or in near future via signature based offline methods. This operational service offers consumers to choose between offline and online methods. The selection of these methods often hinges around the benefits offered by respective benefits. Offline transactions provide float and online transaction using debit card allows taking out cash from the point of sale.
As per the article of ATM and Debit News (07), there were roughly 27 billion transactions through debit cards in the UK during 2006 - 07. The number of transaction has increased from 7 billion and showed a fourfold increment in last 8 years. Many researches conducted in the area of debit card usage identified that this is mostly liked payment instrument by majority of the consumers. Similar explorations for demand-side were conducted independently as well as in groups by considering various payment options. For example, one research paper used the data of SCF (Survey of Consumers Finance) to found that educational attainment is positively related to debit card usage. Other factors to which debit card usage is related are marital status, homeownership status, business ownership and employee with white collar job. The debit card usage is related to net worth and age negatively. Another paper by Klee has shown the extended work to consider SCF data and reported a secular increment in adoption. This adoption is driven by factors like demographics and age. Klee and Hayashi had studied and analysis the consumers circumstances in which they like to adapt debit card and shopping pattern, it was reported that the usage of debit card is more in gas stations and grocery store transactions. Surprisingly the number of transactions at restaurants is lesser than these transactions. Also in addition to above relation, the incidences of self service transaction are positively related to debit card usage.
Online banking: online banking became the means of establishment of online presence for commercial bank. This happened because there was rapid acceptance of Internet access by households and organisations. In year 1995, the first website of bank was launched and after 7 years almost 50 % of UK commercial banks and financial firms start operating their transactional websites. And now by 2007, 78% of commercial banks and financial firms are offering transactional websites (as suggested in bank call report data). And the 97 percent commercial bank deposits are been handled by these commercial bank.
The prime objective of the research conducted was to relate the determinant of bank adoption in terms of online banking and the effect of technology on the performance of the commercial banks. In regards of online banking adoption, Nolle and Lang (2002) reported that the banks which are younger, larger, located in urban area, affiliated to holding company and have fixed higher expenses can offer the transactional websites. In the related research paper about the bank performance for online operations it is reported that adoption of Internet technology has improved the bank profitability. The prime reason for improved performance is through deposit related charges. Another research reported that over a period of time bank has realised high profitability and lower cost which is associated with online banking. They have also mentioned that online banking is a complementary channel and not a substitute of bank branches which physicals serve their customers. Unlike previous studies, Mantel had analysed empirically the characteristics of demographic users. The focus of his paper was on electronic/ online bill payment. Along with other important findings, he reported that the older female, homeowners and people with higher income use online banking to pay their electronic bills.
Prepaid Cards: As clear by the name, they are the instruments in which cardholders pay the money early and deposit the funds in advance and set aside the money for future transactions like purchasing of services and goods. The difference between Debit card and credit card is that debit cards consumes money at the instance of transaction only and credit cards takes money from the consumer after predefined time interval. The amount associated with a prepaid card is either mentioned on the card itself or stored at a database situated remotely. As per the study conducted by Mercator group, the amount of transaction value done by using prepaid card is over £90 billion in the year of 2006. The system of prepaid cards can be defined as:
example gift card specified to a retailer
branded card with payment-network like VISA card or MasterCard
Prepaid cards using closed system are very effective as a substitute of cash in mass transit systems, university campuses and retailers. Open system prepaid cards are comparatively less effective to date, but offer other discounts and additional package to the cardholders. The additional packages include entry to specific clubs and restaurants, fixed percentage discount on purchases and any other money back offers. Cheney et al (2006) discussed in their paper about two different types of prepaid programs based on open system. One is payroll cards and other is general spending reloadable cards. Both of the type's offer operations same as deposit accounts. In 2001, payroll cards were introduced and were specifically attractive for unbanked consumers as they have lesser transaction costs. These types of cards were excessively used to spread disaster relief and welfare benefits. Reloadable cards have been used generally by immigrants and travellers for remittance purposes and were offered by mainly convenience stores and grocery stores.
Few descriptive type researches was conducted regarding existence of prepaid cards and paid attention to certain issues in public policy in context of this payment mode. Furletti (2005) reported the flaws in federal and state customer protection. And also mentioned bank issuers and card associations had extended few safeguards by their own, for example zero liability, charge back provisions. Other publication discussed that there is possibility to utilise the prepaid cards in money laundry schemes. In this it is also mentioned about instance about offshore card insurance and the vulnerability in access of cash at ATM outlets.
Improved production operations
In the last 27 years, we have witnessed significant changes in the processes practiced by commercial banks. The acceptance of electronic transmission in bank to bank retail payments process resulted in tremendous increase in amount of retail business and online banking, which was one major change in bank operations in 70s. In context of intermediation, a steady movement was noticed toward a confident approach in using statistical models. Like, the use of credit scoring has increase substantially in place of manual underwriting. The bank operations also extended into operation based product up gradation like relationship oriented products. Similarly the measurement models of credit risk are widely used while cresting new structure for financial products and operations through securitisation. The overall risk management operations at banks are centrally using statistical modelling through “value at risk” models and stress testing of portfolios. The prime objective of this testing is to assess the portfolio value in terms of significant changes occurring in financial asset returns.
ACH (Automated Clearinghouse):
Ach is an automated mechanism of electronic funds transfer connecting commercial banks through network. The prime use of ACH is repetitive small amount payments. This automated network was introduced in 70s and grew significantly in volume in next decade. They were used extensively for the direct payroll deposits. However, in the last 17 years the process of combining different ACH has occurred and the volume is skyrocketed. As per the data of National Automated Clearing House Association, the volume of ACH transaction has raised from 2 billion to 16 billion in the time period from 1991 to 2006.
The most recent studies on ACH systems are focussed at defining demand and supply circumstances in conjunction with Fed-ACH pricing policies. Bauer et al (1995) studied that because of the lower input prices, economies scale and technology innovations in period of 1979 to 1994 the cost of ACH operations has reduced dramatically. They have also assessed demand elasticity of ACH by using optimally Fed-ACH price changes against time finding. They reported the demand of ACH is highly inelastic. Gowrisankaran et al (2004) has researched on the network externalities for ACH. They have assessed that peer group effects, technological advancement, market dominance and economies of scale are the reasons for network externalities. Ackerberg et al (2006) has assessed and declared the large fixed costs as the barrier to more popular use of ACH payments.
Small Business Credit Scoring (SCBS):
various type of lending technologies has been used by commercial banks in order to lend to small businesses which are opaque in terms of information. Berger (2006) has explained about these technologies in his paper. In 1990s, a new technology; SBCS was introduced and it continued to grow till now. This technology includes assessing the customer database to dig out about the firm owner and comparing this data with firm data using methods of statistical analysis. This is done to forecast the future performance of credit. This technique is widely accepted in consumer credit industry like credit cards, mortgages and automobile loans. They are widely available in low cost and as credit packages which are sold in secondary markets. The experimental studied shown in literature about SBCS focused on the determining factors of bank adoption and circulation of this technology. Another factor was to analyse the affect of SBCS on credit availability. Two research papers have reported after examining statistically the determining factors of timing and probability of big banks acceptance of SBCS. Srinivasan et al (2001) and Frame (2005) both searched an important function for organisational structure in the decision of adoption. Commercial banks with lesser bank charters and comparatively higher number of bank branches would have more ability to adopt and that too in lesser time. This finding concludes that large banking organisation with effective centralised database structure are likely to adopt SBCS. Still the SBCS technology is accepted by the big organisation in banking sector. However, recently one study explored that the small and mid size banks utilises the customer credit score of the main firm owner. Various studies have concentrated on the correlation of SBCS with the credit availability. Three different studies have reported the increase in the volume of lending. One of the literatures has reported the evidence that opaque and risky borrowers are related to more lending; another found that low and high income geographical areas both are related to increased lending.
Asset Securitisation: it is the process of repacking cash flows in order to transform the non-traded assets into “asset backed securities”. Nowadays, in the UK, large originators of retail credit like credit cards, automobile loans and mortgages are widely using securitisation. In the end of year 2007, privately arranged “asset backed securities” and mortgage pools sponsored by federal has almost total £4 trillion outstanding debt amount of the £25 trillion in UK credit industry. In the end of the year 1990, the outstanding debt amount was £700 billion in the £7 trillion industry. There are several articles and books published by different authors discussing the process of securitisation. They describe the analytics needed to value and structure the resulting asset. Consequently, we can only have cursory study of the issues. Normally, asset securitisation transformation includes several steps. Firstly, a group of financial assets is sold to a trust which is legally separated. Against this sale the liabilities are issued i.e. asset backs securities. After this process, the cash payment is received by original owner of the asset and hence able to liquefy its position. However, because the seller is assumed to have better information of the assets than the buyer, the buyer needs credit enhancement in some form. Otherwise, the buyer faces the probability of adverse effect of wrong selection. These credit enhancement is generally in the form of overcollateralization, third party guarantees or by creating the priority claim thru “tranching”. The first two forms to create the credit enhancement are uncomplicated; the tranching requires a little explanation. Tranching includes the generation of two or more types of security determined by their priority of claims. The first seller generally keeps the junior security (“equity”). The meaning of junior security is that he security with lowest payment priority which means the recent absorption of the losses. Other than liquidity, securitisation also have few social benefits if it maintaining the financing of loans in lower cost. This can be done via separating funding and origination. Securitisation has few private benefits, like for the depository institutions which manages their capital positions. One paper presents the experimental evidence that securitisation has provided benefits to the stakeholders of certain ABS. generally for large issuers, lower-quality issuers, first time issuers, bank issuers and frequent issuers. In the securitisation / structured finance area, recently one innovation is introduced, which is collateralised debt obligation (CDOs). As per the publication of Longstaff (2006), these instruments were introduced in the mid 1990s and now have exceeded than £700 billion. Liabilities like CDOs and ABS are generated by financial institution sponsored trusts, which must group and restructure the cash flows priorities. Especially the one associated with several other types of risky financial assets. Goodman et al (2007) research has discussed the purpose of CDOs including their risks and structure. Most of the research papers related to CDO are eccentric at the risk assessment and pricing. There few studies which searches the correlation between systemic risk and CDOs. Also the relationship between banks' lending behaviour and their use of CDOs has been discussed in other papers. There is substantial decline in the subprime mortgage backed security value resulted from a steep increment in the subprime mortgage defaults. Also the value of CDOs backed by such securities is reduced by the expected future defaults. This ultimately resulted in the secondary market for mortgage securities and subprime mortgages freezing up. There are serious consequences because of the subprime mortgages stuck into originator to distributor for leveraged investors whose material is exposed to subprime mortgage credit. This is how the crises of subprime mortgages were evolved in financial crisis at global level. Few economic analysts have indicated to conflicts of incentive inbuilt in the “originate to distribute” model. This was due to the magnification of the crisis resulted from increment in default cases by subprime mortgage borrowers. Ashcraft (2008) discussed and provided seven key points generated from originate to distribute model and how market contributors work towards minimising such frictions. They also offered speculation to break down this process. Another paper described the overview on the structure of securitisation deals of subprime mortgages and provided rating using information from a pool of securitised mortgage.
In the last two decades, financial theory generated a revolution in risk management banking strategy, because in advancement of information technology both in hardware and software aspects. There are two popular ways to manage and measure financial risks; value at risk (VaR) and stress testing. In both the ways, the main objective is to identify the capital required for the bank to maintain its solvency, especially while facing the adverse environments. Stress testing includes creating unfavourable scenarios for interest rate and/ or credit conditions and the assessing assets and liabilities, then ultimately solvency under these unfavourable situations. Fender (2001) proposed a study of stress testing in financial organisation. Berkowitz (2000) discussed few specific inadequacy of stress testing for risk management. Value at risk relies on approach based on probability that assess the distribution of assets. In this test, a bank should describe a level of probability for the return distribution of assets. This probability level should be as outer limit of exposure. After this we need to calculate the economic losses linked with that distribution point. Due to the excessive focus on return distribution, trading books is generally tested using VaR technology. These books are populated by securities which are ready to market. However, the principles discussed here are also used in credit portfolios. There are large number of articles and books written by various authors abou