Based on Joseph Schumpeter

Based on Joseph Schumpeter (Cited in Karol, 2013), financial innovation can be understood as a factor which leads to growth in firms as well as in economies. It refers to new or improved ways of making more profits, either to decrease the production costs or to create and sustain a high demand level.
This chapter also looks at the main theories behind financial innovation, which forms the literature of this study. The six theories explained below are Schumpeter’s theory of innovation, Innovation diffusion theory, Constraint-induced theory, Transaction cost theory and Circumvention theory of innovation.
2.1.1 Schumpeter’s Theory of Innovation
In his work “Theory of economic development”, Schumpeter explained that innovation could be divided into five main types which are as follows:
1. Launching of new product or existing but improved model of the product
2. Applying new processes of production or sales
3. Launching of new market
4. Obtaining new raw material sources or unfinished goods
5. Creating new or destroying present market structures
The Schumpeter theory of profit holds that in order to get greater profits, one must innovate, which leads to competition in the sector. Accordingly, innovations can occur in 4 stages: invention, innovation, diffusion and imitation. He argues that a firm will be profitable when the new product or process will lower its cost of production or increase its demand level. Competitors will eventually imitate the new or improved product as it becomes more popular and its demand start to rise. The innovating firm no longer holds a monopoly power. As such, he concluded that innovation can cause creative destruction. Hence, he points out that innovation continuously reshapes the economy internally and keeps on creating new structures while dismantling old ones.
2.1.2 Diffusion of Innovation theory
The diffusion of innovations theory, based on Everett Rogers, has been contextualised in different fields namely sociology, marketing and communications among others. It relates to the motives and the circumstances under which innovation is spread over time among the different market participants. Tufano notes that innovation spreads when imitators copy successful and profitable banking innovations (Cited in Khraisha and Arthur, 2018). Accordingly, it depends a lot on human capital such as knowledge and innovation is bound to reach to a saturation point over time. According to Rogers et al. (2009), the extent to which a firm endorses a new idea is defined as innovativeness while the diffusion process is known as the innovation-decision making process (as illustrated below) has five steps (Knowledge, persuasion, decision, implementation and confirmation). Furthermore, four categories of adopters have been identified: early adopters, early majority, late majority and laggards. Insert diagram
Rogers suggested certain factors that affect the diffusion of innovation comprises of notably relative advantage (innovation brings improvement to existing ideas), compatibility (whether the innovation is suitable with present values and requirements of adopters), observability (how much is the innovation visible to others), trialability (if the innovation can be tested before being adopted) and complexity (level of difficulty experienced when using the innovation). Hence, he noted that innovations with the above attributes are more likely and quicker to be adopted than others.
Akhavein et al. (2015) found only a few quantitative studies insert footnote on the names of the studies on diffusion of innovations. However, diffusion is only successful when a group adopts innovation either through optional, collective or authority innovation decisions. Difficulty is also experienced when measuring the exact causes of innovation. Al-Jabri and Sohail (2012) observed that the factors which affected the adoption were relative advantage, compatibility, observability while trialability and complexity had no effect and perceived risk had a negative influence on adoption. Akhavein et al. conducted a study on diffusion of financial innovation and found that larger banks have adopted innovations before other banks and that adoption of innovation is positively influenced by the size of the banks and its network.
2.1.3 Constraint Induced theory
According to Merton (1992), financial innovation is considered the “engine” which leads the financial system to its aim of improving economic performance.
Silber, an American economist proposed the theory of constraint-induced innovation, which showed that financial innovation arises primarily because firms want to maximise their profits. (Cherotich et al., 2015) As such, small banks with the most constraints have higher incentives to innovate with new financial products or processes designed to reduce financial costs of the banks (Tufano, 2002). Certain factors such as particular leadership styles tend to ensure an unwavering management style, thereby decreasing the firm’s efficiency. The firm should eliminate these restrictions. Ben-Horim and Silber (1977) carried a ground-breaking study of the constraint-induced notion of innovation and examined the drivers of financial innovation. They discovered that the constraints caused by government regulations encourage firms to innovate. (pg 279)
Nonetheless, Silber’s approach disregards the role of institutions in innovation and since it considers innovation in its excessive adversity, it is not considered as a good incentive for innovation.
2.1.4 Transaction cost theory
The transaction cost theory is explained in a study carried out by Hicks and Niehans in 1983, (Cited in Cherotich et al., 2015), which demonstrated that a fall in transaction costs is a major influence behind financial innovation. The low costs are in turn, caused by technological advances. Therefore, a fall in transaction costs will lead to more innovation by firms and a general enhancement of financial and banking services. Tsuma et al.(2018) investigated the effects of innovation on financial performance which was based on this theory. They found that process innovations led to a fall in transaction costs and consequently led to positive financial performance. This theory is believed to be different from the others as it focuses on a firm’s perspective instead of a macro-economic level.
The transaction cost theory also suggests that product innovation has affects transaction value and as a result, with customized and improved products offered to the bank’s customers, transaction costs can be reduced. (Tahir et al., 2018)
2.1.5 Circumvention theory/ regulation theory
Proposed by Kane (Cited in Cherotich et al., 2015), the circumvention theory believes that financial innovation is driven mostly by the regulations imposed on the finance sector firms by the government. Indeed, over-regulation, imposition of high taxes and other types of sovereign controls tend to increase the operation costs of the firms due to compliance, which in turn leads to lower profit opportunities. Consequently, regulatory constraints imposed led the firms to engage in market and regulatory innovation (Achieng et al, 2015). This situation can be illustrated in the case of capital requirements in banks, where a bank has to comply with the regulations issued by the Central bank and hence, incurs certain compliance costs. As such, regulations stimulate innovation. Innovations such as Eurobonds and equity swaps have been created especially to bypass regulations (Tufano, 2002).
Khraisha and Arthur (2018) noted that innovative processes and products such as securitization were effectively created to avoid high costs due to legal compliance.
Despite regulation inducing financial innovation, critics argue that regulation requirements impede innovations. Nonetheless, regulations have been increased after the financial crash of 2007/2008, partially caused by the trend of deregulation which prevailed during this period. Furthermore, through regulation, many mechanisms have been designed and implemented to level the ‘playfield’ (Khraisha and Arthur, 2018).

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