FEDERAL RESERVE BANK

OF PHILADELPHIA

Robert M. Hunt*

*: The views expressed here are my own and not necessarily those of the Federal Reserve Bank of Philadelphia or the Federal Reserve System.

Innovation in Financial Services and PaymentsMay 16-17, 2002

Session onInformation, IT and Property Rights

Overview

• Hauswald-Marquez show us how innovations, and their spillovers affect lending markets– There are tantalizing hints of the implications

for the incentive to innovate– Highlights the role of appropriability

• Thomas shows us that FIRE has obtained a new tool to enhance appropriability--patents on methods of doing business.

• What can we conclude about effects on the industry?

Financial Services as a High Technology Industry

• IT investments are very large– Mid 1990s, US banks spend 15% of non-interest

expense on IT, the largest consumers of IT.

– Used/developed $23 billion in software in 1998, the largest of any U.S. industry.

• Significant investments in R&D (NSF)– $1.6 billion 1998, 2x 1995 level

– 17,000 scientists and engineers, 3x 1995 level

• Un-measured R&D is likely much higher.– In Canadian data, most R&D in FIRE is software.

Key Insights from Hauswald-Marquez

• Innovations may increase/decrease information asymmetries between lenders– These determine the primary beneficiaries of innovation:

incumbent lenders or consumers

– Implications for industry structure and competition

– Results are less stark when we generalize the model

• Access to technology is important– Spillovers

– Technology vendors

• Implications are tentative– Would like a model of dynamic innovation

Insights from Hauswald-Marquez (cont.)

• Screening effort is increasing in the quality of IT, but decreasing in the extent of spillovers

• It is possible that some limitation on spillovers is welfare improving, even though it is costly– efficient monitoring

– incentives to innovate

• Effort expended preventing spillovers is increasing in the value of IT.– But this effort is not a monotonic function of the

propensity for information to leak out.

Insights from Hauswald-Marquez (cont.)

Spillovers in the Absence ofPatents

Value of IT Weak StrongA little Less More

A lot More A lot more

Insights from Thomas

• Financial Institutions have a new means of regulating spillovers - patents on computer software and business methods.– Software was an evolution

– Business methods occurred rapidly

• Financial institutions are exercising this option. – A surge in these patents

– Participation by banks and vendors

Insights from Thomas (cont.)

• There are concerns about patent quality– PTO has to learn about new things

– In general, is PTO examination good enough?

• Patent standards have also been relaxed– Less significant inventions qualify for protection

• Concerns about hold-up, defensive patenting– Examples of litigation (automated underwriting, online

banking)

– Examples of substantial licensing fees (call center patents)

Endogenous Screening

• Now the same screening technology is available to both lenders– In a mixed strategy equilibrium, improved IT increases

expected price competition among lenders

• But the authors argue the mixing equilibrium is less plausible for established markets– Couldn't better IT decrease the significance of

established relationships?

• What about effort expended to inhibit innovations? – choosing a rival that screens or not.

Implications for Innovation

• We'd like to use a dynamic model – Racing and sequential innovation

• There is an optimal level of appropriability– Imitation cost or lead time

– Patent Standards - Nonobviousness

• The optimal standard is more strict for rapidly innovating industries– Too many patents dissipate more rents than they create

– The effect is most pronounced when innovation is rapid

– This holds even in the absence of transactions costs

Policy Implications

• Patents will play a more important role in this industry than in the past

• But in the US, patent standards have been relaxed– There are also issues about the quality of patents

granted

• It is not at all clear the patent system is calibrated to maximize innovation in financial services

• We should think about the significance of access to technology on industry structure and competition

Information, IT and Property Rights

"Soft" Business Method Patents

0100200300400500600700800

84 86 88 90 92 94 96 98 '00

Source: CHI Research and author's calculations

A Few Interesting Financial Patents

Patent No. Year Description

4,346,442 1982 Securities Brokerage Cash Management System (CMA)

5,532,464 1996 Electronic Check Presentment

5,677,955 1997 Personal Online Banking (Intuit)

5,677,955 1997 Electronic Funds Transfer Instrument

5,848,400 1998 Electronic Check Clearing and Settlement

5,978,485 1999 Foreign Exchange Transaction System

6,017,063 2000 Financial Certificates (inflation indexed bonds?)

6,076,074 2000 Intraday Netting Payment Finality

6,078,903 2000 Modeling Risks of Loans in a Financial Portfolio (KMV)

6,112,190 2000 Method and System for commercial Credit Analysis (Citi)