verhagen, n. (2011). survival of the fittest, not only the best survive - an explorative research on...

8/6/2019 Verhagen, N. (2011). Survival of the Fittest, Not Only the Best Survive - An Explorative Research on the Selection E

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Survival of the fittest, not only the best survive:An explorative research on the selectionenvironment for financial innovations

N. Verhagen

Radboud University, Nijmegen

June 2011

Dr. P.M. Vaessena and Dr. P.E.M. Ligthartb

a Supervisor Radboud University, Nijmegenb Reviewer Radboud University, Nijmegen

Author: Nick Verhagen, Molenstraat 37, 6511 HA Nijmegen, The NetherlandsE-mail: [email protected], Student number: 0745030


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Acknowledgements

My special thanks go to Dr. Vaessen as my supervisor and Dr. Ligthart as reviewer of thisthesis. They both gave me valuable insights and provided useful suggestions that helped me to

further improve this Masters thesis.

Also I would like to thank the experts who participated in the interviews and by doing so

dedicated some of their valuable time to my research.

At last I would also like to thank everyone else who helped me, all in their own way, with this

thesis.

Nick Verhagen


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Summary of Contents

1 Introduction .........................................................................................................................52 Financial innovation: An introduction ..................................................................................63 Theoretical framework ....................................................................................................... 144 Methodology ..................................................................................................................... 355 Data analysis ..................................................................................................................... 406 Conclusion ........................................................................................................................ 65References ............................................................................................................................ 72Appendices ........................................................................................................................... 79


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Contents

1 Introduction .........................................................................................................................52 Financial innovation: An introduction ..................................................................................6

2.1 The financial innovation process ...................................................................................62.2 The financial crisis and the influence of financial innovations .......................................82.3 The characteristics of the Dutch financial services sector ............................................ 11

3 Theoretical framework ....................................................................................................... 143.1 Evolutionary economics .............................................................................................. 143.2 Selection environment................................................................................................. 153.3 The actors in the selection environment ...................................................................... 183.4 A practical application of the selection environment ................................................... 23

3.4.1 Market dimension ................................................................................................ 233.4.2 Institutional dimension ......................................................................................... 283.4.3 Knowledge dimension .......................................................................................... 32

4 Methodology ..................................................................................................................... 354.1 Data collection and analysis ........................................................................................ 354.2 Selection of respondents ............................................................................................. 374.3 Interview topics .......................................................................................................... 38

5 Data analysis ..................................................................................................................... 405.1 Analysis of the market dimension of the selection environment .................................. 405.2 Analysis of the institutional dimension of the selection environment ........................... 55

6 Conclusion ........................................................................................................................ 656.1 Discussion .................................................................................................................. 656.2 Conclusion .................................................................................................................. 686.3 Recommendations ....................................................................................................... 696.4 Limitations of this research ......................................................................................... 706.5 Suggestions for future research ................................................................................... 71

References ............................................................................................................................ 72Appendices ........................................................................................................................... 79

1. Historical overview of innovation in the financial services sector .................................. 79


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List of figures and Tables

Figure 1: Conceptual model .................................................................................................. 17

Figure 2: Good and bad innovations ..................................................................................... 22Figure 3: Combined conceptual model .................................................................................. 34

Table 1: Examples of financial innovations.............................................................................7Table 2: Overview of the stages in the (financial) innovation process .....................................7Table 3: Overview number of organizations and employees between 2006-2009 ................. 11Table 4: Retail Market share Dutch Banks ........................................................................... 12Table 5: SME Market share Dutch Banks ............................................................................ 12Table 6: Innovation types .................................................................................................... 24Table 7: Organization types ................................................................................................. 24Table 8: Number of innovations per year ............................................................................. 24Table 9: Laws and regulations ............................................................................................. 29Table 10: Classification scheme of the experts answers regarding hypotheses ....................... 36Table 11: Characteristics interview candidates ...................................................................... 38Table 12: Interview hypotheses per dimension of the selection environment ......................... 39Table 13: Overview opinions h1a ......................................................................................... 42Table 14: Overview opinions h1b ......................................................................................... 43Table 15: Overview opinions h1c ......................................................................................... 45Table 16: Overview opinions h1d ......................................................................................... 47Table 17: Overview opinions h3a ......................................................................................... 49Table 18: Overview opinions h1e ......................................................................................... 51Table 19: Overview opinions h1f .......................................................................................... 52Table 20: Overview opinions h3b ......................................................................................... 54Table 21: Overview Market and related Knowledge dimension hypotheses .......................... 55Table 22: Overview opinions h2a ......................................................................................... 57Table 23: Overview opinions h2b ......................................................................................... 58Table 24: Overview opinions h2c ......................................................................................... 60Table 25: Overview opinions h2d ......................................................................................... 62Table 26: Overview opinions h3c ......................................................................................... 63Table 27: Overview Institutional and related Knowledge dimension hypotheses ................... 64Table 28: Overview hypotheses ........................................................................................... 66


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1 Introduction

The financial crisis that started in 2008 can be linked to the exploitation of financial

innovations that were used to create perverse financial innovations that were sold across the

world (Den Haan & Sterk, 2010). Of course, not all financial innovations lead to trouble. But

some unwanted financial innovations were not noticed by the gatekeepers and made it through

to the market (Boot in Volkskrant, 2010).

The commonly held view in literature is that innovation is by definition a good thing

(Hadjimanolis, 2003). How could it happen then that some financial innovations lead to so

much trouble? While innovations are perceived as good things correspondingly barriers toinnovation are viewed as bad things. Piatier (1984) suggests that innovation barriers can also

have a positive role, suggested is that barriers filter out the bad innovations to let only the

good pass. The positive role of innovation barriers is also implied in evolutionary economics

(Geenhuizen & Nijkamp, 2002). In this thesis I depart from the evolutionary approach which

assumes that selection barriers in the economic environment block adverse innovations and

allow good innovations to pass (the survival-of-the-fittest-principle). This is important

because, according to Krugman (2007) the financial crisis is a clear example of a failing

selection environment.

This thesis has two goals: 1. to elaborate on the selection environment concept by looking at

adverse financial innovations and 2. to do a systematical analysis of the selection environment

that accepted adverse financial innovations and influenced the start of the financial crisis. The

theoretical relevance of this thesis is that it elaborates on the concept of the selection

environment for financial innovations of which not much is written in academic literature.

The practical relevance of this thesis is that it analyses the elements of the dimensions in the

selection environment for financial innovations that failed.

This thesis starts by explaining the concept of financial innovation to the reader, second an

introduction to the financial services sector in the Netherlands will be given, followed by an

short analysis of the financial crisis. The theoretical framework focuses on the selection

environment, the actors and their relationships. In the methodological chapter a justification

of the used research methods is given. This is followed by a data analysis and the final chapter

will pose a discussion and a conclusion to the main question of this thesis.


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2 Financial innovation: An introduction

This chapter has as goal to introduce the reader to the concept of financial innovation and how

this is related to the financial crisis, the focus will be on the Dutch financial services sector

and especially on banks. The concept of innovation and especially financial innovation will be

explained, also the stages and activities of the process will be identified. Next, how the

financial crisis was influenced by financial innovations will be explained, followed by the

characteristics of the financial services sector in the Netherlands 1. After reading this chapter

the reader will have an understanding of financial innovations, the effect on the financial

crisis and the Dutch financial services sector.

2.1 The financial innovation process

This paragraph first deals with the question what innovation is, this is followed by some

specific characteristics of financial innovations and how the process unfolds at organizations

in financial services sector. By reading this paragraph an understanding is created of what

financial innovations exactly are and how this process works at organizations in the financial

services sector.

What is innovation exactly and is it the same as invention? According to Fagerberg (2005)

there is an important distinction between the concepts of innovation and invention: Invention

is the first occurrence of an idea for a new product or process, while innovation is the first attempt to

carry it out into practice.. Tidd, Bessant & Pavitt (2005) state that: Innovation is more than

simply coming up with good ideas: it is the process of growing them in practical use. . From an

evolutionary perspective three stages are identified in the innovation process: a variation stage:

how new innovations arise; a selection stage: what innovations are strong enough to survive; a

retention stage: which innovations remain and will be continued to use (Nelson & Winter,

1982). Kline & Rosenberg (1986) suggest that:It is a serious mistake to treat an innovation as if

it were a well-defined, homogenous thing that could be identified as entering the economy at a precise

dateor becoming available at a precise point in time..

1 In appendix 1 an elaboration is given on innovation in the financial services sector.


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Tidd, Bessant & Pavitt (2005: 21) distinguish Product from Process innovations: Product

innovations are defined as what is offered to the world, Process innovations as how these

offerings are created and delivered. An innovation can be incremental (doing what we do, but

better) or radical (doing something different) (Tidd, Bessant & Pavitt 2005: 27). This thesis

explicitly focuses on innovations related to financial products, called financial innovations.

Some examples of the different types of financial innovations are (Spelier, 2008):

Type of financial innovation Example financial innovation

New product or service Investment products (ABN Amro Turbos)

Distribution of a product Selling credit cards through retailers (Primeline Credit Cards)

Value chain of an organization Supply chain finance

Business model Only online banking (Bizner)

Brand Communication Educate youngsters to manage money (ING Direct)

Table 1: Examples of financial innovations

According to Tufano (2002) the need for financial innovations arises due to imperfections in

the environment, such as: taxes, regulations, information asymmetries, moral hazard and

transactions costs. To deal with the issues identified by Tufano (2002) improvements have to

be made to the existing situation. These improvements can be based on certain flaws in the

selection environment that make it possible for financial organizations to create more returns

by exploiting new technologies that offer the possibility to reduce costs or to create

sophisticated risk calculation models. To understand better how financial innovations evolve

at financial organizations an elaboration will be given on the stages and activities of the

process. Dankbaar & Vermeulen (2002) and Vermeulen (2005) identified that organizations

in the financial services sector distinguish six stages in the innovation process. These stages

are somewhat similar to the five innovation stages identified by Tidd, Bessant & Pavitt (2005),

although some important differences exist, the stages are compared in table 1.

Stage Dankbaar & Vermeulen (2002); Vermeulen (2005) Tidd, Bessant & Pavitt (2005)

1 Idea generation and concept development Scan and search the environment

2 Concept specification Look for potential triggers3 Product building (could also be part of implementation) Generate resources for the option

4 Testing: Internal and external marketing Implement innovation

5 Implementation Reflect upon previous stage

6 Introduction

Table 2: Overview of the stages in the (financial) innovation process

In comparison to the stages identified by Dank & Vermeulen (2002, 2005), the fifth stage of

Tidd, Bessant & Pavitt (2005) is missing. It seems that in the financial services sector no

specific stage is dedicated to reflection upon the innovation process, although the fourth stage

of Testing may generate some feedback. Research has shown that only 21 percent of the


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organizations in the financial services sector evaluate the innovation process (Dankbaar &

Vermeulen, 2002). The low percentage of organizations that evaluate the innovation process

is remarkable, because by evaluation it is possible to see where and why difficulties arose in

the selection environment and to learn how to deal with these issues in the future.

This paragraph has given an overview of the concept of innovation and financial innovation,

together with the overview of the stages in the innovation process the reader will understand

the main subject of this thesis. In the next paragraph the relation between financial

innovations and the financial crisis will be explained.

2.2 The financial crisis and the influence of financial innovations

This paragraph has as goal to explain the relation between financial innovations and the

financial crisis. First, the innovations that are assumed to have acted as a trigger for the crisis

will be introduced. Second, an analysis of the effects of the financial crisis will be given and

as last the influence of the financial crisis on the Dutch economy will be explained. By

identifying these topics the reader will get a thorough understanding of how financial

innovations and the financial crisis were related to each other.Financial innovations and their influence on the financial crisis

Financial innovations were mentioned as one of the causes of the financial crisis (Shiller,

2009). While only a few really understood the innovative products that were created, many

were attracted by the short term financial gains and lost sight for the long term risks (Den

Haan & Sterk, 2010). In the New York Times a historical example was given in which the

development of financial innovations is compared to the development of steam engines:

James Watt, who invented the first practical steam engine in 1765, worried that high-pressure steam

could lead to major explosions. So he avoided high pressure and ended up with an inefficient engine.

It wasnt until 1799 that Richard Trevithick, who apprenticed with an associate of Watt, created a

high-pressure engine that opened a new age of steam-powered factories, railways and ships. That is

how innovation often proceeds by learning from errors and hazards and gradually conquering

problems through devices of increasing complexity and sophistication. Our financial system has

essentially exploded, with financial innovations like collateralized debt obligations, credit default

swaps and subprime mortgages giving rise in the past few years to abuses that culminated in disasters

in many sectors of the economy. (Shiller, 2009).


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One of the most well known financial innovations that backfired is the credit default swap

(CDS). In a CDS the risk of nonpayment (default) between two parties is transferred to a third

party who accepts the risk of default in return for a fee (Stulz, 2010). Because of the fact that

CDSs were bundled and traded constantly, buyers lacked proper research on the assets that

underlied their investments. Another well known financial innovation is the collateralized

debt obligation (CDO). CDOs are bundles of mortgages or other loans that are traded

constantly, by doing this banks clean their balances and create additional financial space to

invest (Duffie & Grleanu, 2001). Together with normal mortgages, subprime mortgages

were bundled in CDOs and traded many times by financial organizations around the world.

The focus on making more profit by trading these CDO & CDS bundles overruled the need

for a proper due diligence on the assets on which these products depended. Financial

innovations developed by foreign banks were traded by Dutch banks, some specific financial

innovations for the Dutch market were: mortgages combinations with doubtful investment

constructions (resulting in unforeseen high monthly payments, DSB bank); single premiums

(with high percentages used for the costs, Woekerpolissen); constructions such as buying

stocks with borrowed money (leading to a debt when stock prices decline, Dexia).

The beginning of the financial crisis and effects of it on the environment

The start of the financial crisis can be traced back to the introduction of new financial

instruments and to far-reaching reforms by governments which changed legal and regulatory

frameworks of financial markets (Boz & Mendoza, 2010; Krugman, 2007). One of these

changes were the low interest rates given by the U.S. Federal Reserve (national bank). After

2001 it was fairly cheap for financial organizations to borrow money, because of these low

interest rates the motivation for strict control on credit risks was less present. One of the

effects was that banks would grant U.S. citizens with a bad credit history (subprime status)

also a mortgage. With a 157 percent increase of prices of houses in the U.S. between 1992-

2007 and the fact that three-quarter of the mortgages in the U.S. were adjustable ratemortgages the effects of increasing interest rates is evident. Two million U.S. homeowners

were faced with payment difficulties and resulting repossession by the mortgage lender in

2007. As a result of the weak housing market in the U.S., mortgage lenders faced severe

income losses in 2007. (NRC, 2009). Bear Sterns was the first bank that in June 2007

admitted that two of their investment funds in mortgages (CDOs) incurred major losses, even

after a capital injection of $3.2 billion by the U.S. government in July the fund went bankrupt

in Augustus 2007. In the months following more banks and financial organizations had to

write off on their investments in financial innovations, such as CDOs. As a result a number of


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governments had to invest billions of dollars in banks and other financial organizations in

order to prevent them from going bankrupt. Banks in Iceland, Ireland, Netherlands, Portugal,

Sri Lanka, United Kingdom and the U.S. were even nationalized by their governments in

order to protect the local economy for the negative consequences of their bankruptcy (OECD,

2010). In April 2009 the World Bank and IMF reported that the loss of all banks and other

financial organizations as a result of the financial crisis was estimated at $4.05 trillion and

that $1.1 trillion was invested in programs to resolve the effects of the crisis (Lander, 2009).

The effects of the crisis became also visible on the global stock markets, according to a

Standard & Poors report January 2008 was the worst month ever for the stock markets. The

result was a worldwide recession which indicated that the effects of the financial crisis echoed

also in other sectors.

The effect of the financial crisis and financial innovations on the Dutch Economy

The support of the Dutch government given to banks had a two-sided impact on the market,

on one side it saved some banks from bankruptcy and thus reduced the negative effects on the

market, but it also created false competition on the market and could thus induce adverse

behavior by the management of banks (Van der End, Verkaart en Van Dijkhuizen, 2009). The

European Commission (EC) therefore reviewed government support on three ground rules: 1.

Banks that receive support had to be life viable on the long run without the support, 2. The

different stakeholders in the supported bank all had to bear a part of the restructuring costs, 3.

Measures had to be made to reduce the effects of disturbed competition on the market

(KPMG, 2009a). Compared to international competitors the health of Dutch banks was

doubtful around 2004, this was a result of low profits on mortgages and low returns on normal

bank activities as compared to banks in other countries (Deckers in Van der Velde, et al.,

2004). Too much interconnectedness between saving and investment bank activities within

the banks was mentioned as one of the issues that influenced the financial crisis (Commissie

De Wit, 2010). In the Netherlands mortgage and normal bank activities are also not separated,as is obligated in the U.S. (Van der Velde, et al., 2004). Because of the interconnectedness of

the different activities of banks, the problems became also interconnected. At the end this

affected not only financial organizations, but also other stakeholders in the environment .

This paragraph has shown how financial innovations and the financial crisis are related and

what the effects of the financial crisis were. The next paragraph will especially focus on the

Dutch financial services sector and the innovation capability.


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2.3 The characteristics of the Dutch financial services sectorThis paragraph gives the reader an overview of the dynamics of the financial services sector

in the Netherlands, considerable attention is paid to the market share of Dutch banks. This is

followed by an analysis of the innovation capability of the Dutch financial services sector,which is also compared to that of the manufacturing industry. By reading this paragraph an

understanding of the sector dynamics and the innovation capability will be created, this helps

to understand the line of reasoning used in this thesis.

Dynamics of the Dutch financial services sector

According to the CBS (2010) 17,870 organizations and 270,000 employees were active in the

Dutch financial services sector in 2009. Table 2 gives an overview of these figures from

before as during the financial crisis.2006 2007 2008 2009

Org. Emp. Org. Emp. Org. Emp. Org. Emp.

Banks 3,660 157 3,960 159 4,530 157 4,645 154

Insurance and pension funds 585 61 705 60 660 58 470 57

Other financial services 11,415 59 12,045 59 11,840 62 12,755 59

Sector total 15,660 277 16,710 278 17,030 277 17,870 270Table 3: Overview number of organizations and employees between 2006-2009 ( Emp. *1,000)

There is a large group of other financial services which is explained by the OECD (2007) as:

Intermediaries operate between banks and the end-consumers, particularly in the market for

mortgages, so did banks only sell 40% of mortgages directly to consumers and 60% was sold

indirectly via agents in 2002 (up from 38% in 1985).

Traditionally the financial services sector had tight institutional controls and high entry

barriers which created not the best climate for innovations. Over the last decades this climate

changed and innovations became needed for organizations to stay competitive in the market

(Vermeulen, 2004). Since the 1990s innovations in the financial services sector became more

frequent as a result of international competition (Van der Velde, et al., 2004). This created a

pressure on operational accomplishments, because weaknesses in the business could not be

covered up anymore by good investment results. Against this background a number of large

scale change projects were started in the financial services sector, which had as goal to use the

synergy advantages of earlier mergers, to increase the commercial power and to improve the

operational results (Van der Velde, et al., 2004).

ABN Amro, ING and Rabobank are the largest banks in the Netherlands, together they had a

market share in both the retail as the SME market of approximately 75-80% in 2006 (see table

4 and 5) (OECD, 2007). Seen is that the SME market is more heavily concentrated than the

market for consumers. The competitive fringe are small competitors that compete with large


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competitors: In the competitive fringe are Fortis, S NS and the category other. In consumer

banking this fringe has on average a 30 percent market share, while in the banking market for SMEs

the average is 20 percent(OECD, 2007).

Market share in retail market (%) ABN Amro Rabobank ING Fortis SNS Bank Other

Current account 20 30 40 5 5 -

Consumer loans 25 20 25 10 5 15

Mortgages 15 25 20 10 10 20

Saving accounts 20 30 25 10 5 10

Asset managements / mutual funds 25 20 15 15 - 25

Table 4: Retail Market share Dutch Banks (OECD, 2007)

Market share in SME market (%) ABN Amro Rabobank ING Fortis Other

Loans + current account 35 25 25 10 5

International payment services 35 25 25 10 5

Export financing 35 20 30 10 5

Deposits/savings 15 25 25 15 20Table 5: SME Market share Dutch Banks (OECD, 2007)

Bikker and Spierdijk (2007) suggest that the high concentration of banks is a consequence of

strong competition on the Dutch market. Boot and Schinkel (2007) suggest that the relation

between concentration and competition is not always negative. High concentration does not

automatically leads to low competition. In a stable market with a few players and a low

potential of new entrants it is possible that the incentive to compete for another banks

customers is absent, competing on price leads to smaller profits on existing customers. The

focus will therefore be mostly on attracting new customers on the markets, such as new home

owners and students (Boot & Schinkel, 2007). Compared to smaller banks large banks also

profit from their brand name and they are more active in creating complex products and

services for large organizations, these tailor made products also generate higher profit margins

(Bikker & Spierdijk, 2007).

The next part will look more closely at how innovative the Dutch financial services sector is.

The innovation capability of the Dutch financial services sector

Drew (1995) stated that innovation is becoming even more important for organizations in the

financial services sector than it is for their counterparts in the manufacturing industry,

financial organizations should therefore follow the innovation footsteps of their industrial

counterparts. Data of the CBS (2010) on innovation in the Netherlands shows that in 2008 out

of the 1,461 organizations in the financial services sector questioned, only 428 (29%) firms

were innovative. The question then is, is the Dutch financial services sector as innovative as

the Dutch industrial sector? One reason why this may not be the case can be explained by the

fact that in industrial organizations product development has always been their second nature,


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while in the financial services sector innovation is something from the last decades (Van der

Velde et al., 2004). Dankbaar & Vermeulen (2004) concluded the same as Drew, but saw that

almost 10 years later the financial services sector had not progressed very far in the practical

application of the insights derived from their industrial counterparts.

CBS (2010) showed that 13 percent more Dutch industrial organizations (42%) were engaged

in innovative activities in 2008, also 20 percent of these organizations had more innovation

expenditures then organizations in the financial services sector. Of the organizations

questioned in the financial services sector 96 percent finished their product innovations, of

which 61 percent was done by the organizations alone, 33 percent in collaboration with a

partner and six percent was outsourced. 64 percent of the organizations had also done some

form of process innovation. The figures show that not even a third (29%) of the financial

organizations was innovative. The fact that the majority felt no need to innovate, could be

because of the barriers they encountered, but maybe a lack of competition did not created an

incentive to innovate. Of the organizations that were innovative four percent did not finish

their innovations, in total 42 percent of the innovative organizations experienced some form

of barriers during the process. Remarkable is that only 5 percent of the financial organizations

received financial support from the government, compared to 19 percent of the industrial

organizations. This leads to the following assumptions: first, governments are not in favor of

financial innovations. Second, financial organizations do not want to have government

support and third, financial organizations do not know how to attain support for their financial

innovations. Whatever the real reason may be clear is that a discrepancy exists between

financial organizations and governments concerning financial innovations.

This paragraph has determined the size of the financial services sector and the market share of

Dutch banks, also was shown what the innovative capability of the sector was as compared to

the manufacturing industry.

This chapter has introduced the reader to the concept of financial innovation, to the effects of

the financial crisis and the relation with financial innovations and to the dynamics of financial

services sector in the Netherlands. In the next chapter, the selection environment concept, the

influence of the different actors in the selection process will be explained and also a practical

application of the selection environment for financial innovations will be given.


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3 Theoretical framework

The theoretical framework will introduce the reader to what existing literature states about the

selection environment and the innovation actors in it. The following structure will be used for

this chapter: First, theory of evolutionary economics will be explained. Second, a definition of

the selection environment and the elements of which it consists will be given. Third, the

actors that are involved in the selection process will be identified. Fourth, the working of the

selection mechanisms will be uncovered. As last the theoretical model will be applied to

specific elements of financial innovations, of which also the hypotheses for the data collection

will be derived. The goal of this chapter is to introduce the reader to what the existingliterature states about these concepts and how this is related to selection of financial

innovations by the environment.

3.1 Evolutionary economics

This paragraph introduces the reader to the theory of evolutionary economics by comparing it

to evolutionary biology. To do this the differences, but also the parallels between both

theories are identified. This helps to create an understanding of the theory in which the

selection environment concept is embedded. From an evolutionary economics perspective

three stages are identified in the innovation process: a variation stage: how new innovations

arise; a selection stage: what innovations are strong enough to survive; a retention stage:

which innovations remain and will be continued to use (Nelson & Winter, 1982). These stages

are also recognized in biological evolutionary theory.

DifferencesMany concepts from evolutionary economics are derived from biological evolution. Although

the line of reasoning is somewhat similar in both theories, important differences do exist. To

give an example of one these differences, 100,000 years ago a group of brown bears became

isolated from their congeners, the following generations of this group of isolated brown bears

evolved into polar bears, this variation in their species was needed to survive the environment

they lived in (Lindqvist, et al., 2010). This indicates that biological evolution is not

intentional, but that it is randomly distributed (McKelvey, 1996). In comparison, economic

evolution is the result of purposive behavior of humans. So can the beginning of the internet


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be traced back to the wish of the U.S. government to exchange information in a nonphysical

way (ISOC, 2011). Another important difference is that in biological evolution each organism

can only try out one combination of genes in a lifetime and that the population has a diversity

of similar genes (survival of the fittest the best variations retain), while in economic

evolution one and the same agent can try out a continuous range of alternatives during his

lifetime (McKelvey, 1996). E.g. The brown bears could only try out the genetic variations

they received at birth, while economic agents can continuously try out different variations.

Parallels

Although important differences exist, also some parallels between these theories can be

found. Whereas biological evolution relies on the genes of species to transmit information

between generations, economic evolution relies also on routines for the transmission of

knowledge, skills and behavior in the population, these routines are considered as the genes of

an organization. (McKelvey, 1996; Belt & Rip, 1987). Evolutionary economics sees

organizations as more or less loosely structured clusters of routines(Belt & Rip, 1987). With

routines acting as genes in the economic environment, mutations or changes in the routines

are the economic variations, such as innovation, in the environment. The outcomes of these

routines are judged by the selection environment, in biology the selection environment exists

of analogous types. The economic environment consists of agents which act as selectors and

automatically determine which routines are viable enough to survive and lead to stability in

the environment (Belt & Rip, 1987; Boschma, Frenken, & Lambooy, 2002; Vermeij, 2009).

Clear is that new variations such as financial innovations can be explained by evolutionary

economics. Which variations survive depends on the selection environment. The next

paragraph will therefore explain the selection environment concept to the reader.

3.2 Selection environment

As stated before this thesis focuses especially on the selection environment for financial

innovations, this paragraph will explain to the reader what the selection environment is and

how it works.

What is the selection environment?

Besides a place to live in, the environment also acts as a place where opportunities arise and

are selected by sustaining them (Boschma & Lambooy, 1999). Although the selection


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environment works as a filtering mechanism that decides which innovation is bound to fail or

to become a success, it does not prevent the unpredictable and thus the chance effect through

which new variety enters the environment (Van Geenhuizen & Nijkamp, 2002). This suggests

that not the rational individual adapts to the environment, but that the environment is clearly

in control of selection, although the environment provides feedback on new variety that enters

(Iacobuta & Phoata, 2008). Selection in evolutionary economics is the reduction of variety

through a competitive process, which is determined by the characteristics of the relevant

selection mechanism (Ramazotti & Rangone, 2000; Wijnberg, 2004). Changes in the selection

environment such as interactions with and feedback from the environment affect the

incentives and disincentives for organizations to invest in innovative search processes

(McKelvey, 2001).

Malloy & Sinsheimery (2004) state that the selection environment helps to identify: 1. The

nature of the mechanisms by which firms learn about potential innovations, 2. The nature of

the costs and benefits considered by the firm in deciding whether to adopt the innovation, 3.

The nature of the firms search routines and 4. The manner in which consumer preferences

and government regulation influence what is profitable. These authors suggest that the

selection environment is clearly in control of selection by filtering the innovation

opportunities created by organizations and that it gives feedback on the dynamics introduced.

An understanding of the working of the selection environment helps to anticipate on the

responses of the system to proposed variations (Malloy & Sinsheimery, 2004). Selection

mechanisms can act both as barriers or as facilitators, although many barriers arise due to a

lack of facilitators (Hadjimanolis, 2003). It is important to be aware of the fact that facilitators

of an innovation can turn into barriers and the other way around as the organization evolves

during its life cycle or if external conditions may change (Koberg et al., 1996). The selection

environment influences the innovation process by first, providing feedback to the innovator,

this helps an innovator to adapt his innovation to the selection criteria and second by

accepting or rejecting the innovation (e.g. financial products that are not accepted by the

market). Piatier (1984) identified several characteristics of barriers, the origins of barriers can

be exogenous (from various sources) or endogenous (from sources within the innovation

process), they can be general (affecting all organizations) or relative (affecting just a few

organizations), the effects of this can be direct or indirect. Both tangible and intangible factors

can influence the selection process. Tangible factors are the local sector structure, local

institutions and regional policies and regulations, intangible factors are culture, social capitaland the extent of relevant local networks (Hadjimanolis, 2003).


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Selection mechanisms have a dynamic nature, this evolutionary character increases the

difficulty to assess the impact of it (Hadjimanolis, 2003; Piatier, 1984). According to

Hadjimanolis (2003) the impact of selection mechanisms can be evaluated per stage of the

innovation process. The innovation process can be influenced by the selection environment in

one of the following ways, by 1. Blocking the development of an innovation, 2. Generating

extra costs in time or money, 3. Disrupting the process (when it cannot be calculated in time

or money) or 4. It can act a positive factor (Piatier, 1984). Malloy & Sinsheimery (2004)

suggest that information flows (e.g. feedback) are such a positive factor, recognizing these

information flows can uncover the working of the selection mechanisms.

Within the selection environment for innovations three dimensions are distinguished by

McKelvey (2001): a Market, an Institutional and a Knowledge (which co-evolves with the

other two) dimension. Other researchers have also proposed similar dimensions in the

selection environment (Hadjimanolis, 2003; Lambooy, 2004; Ma & Nakamori, 2005; Piatier,

1984; Wijnberg, 1994). McKelvey (2001) states that these three dimensions can be seen as

collective aspects within a process of socio-economic development, they link the decisions

and behaviors of individual actors. The three selection mechanisms will be described further

in the following paragraphs, because as McKelvey (2001) stated:The three dimensions define

the boundaries in which innovation takes place, but they also give incentives and disincentives to

innovate..

Figure 1: Conceptual model

The conceptual model in figure 1 is a graphic representation of the question that this thesis

tries to answer. The model shows how innovations that are not yet adopted by the

environment are tested against the three dimensions. Each of the dimensions provides

feedback to the innovator. The assumption is that financial innovations are selected by these

three environmental dimensions and by looking more closer at them tried is to find out how it

can be explained that some adverse financial innovations slip through and by pass these

selection barriers in the environment.

Feedback

Innovation idea

Market dimension

Knowledge dimension

Institutional dimension

Selection environment


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This paragraph has introduced the reader to the selection environment concept and the

working of it. It will help the reader in gaining a thorough understanding of the environment

that surrounds innovating actors. In the next paragraph the focus will be on identifying the

actors in the selection environment and what their exact relationship is with banks.

3.3 The actors in the selection environment

McKelvey (1996) stated that the selection of innovations is a social process, because it

involves not solely decisions made by innovative agents but also by others. Schot (1992)

shows that three types of actors can be distinguished in the innovation process: 1. Those that

are directly involved in the formulation (e.g. product development department), 2. Those that

selectively influence variations (e.g. stakeholders), and 3. Those that couple variation and

selection (e.g. corporate social responsibility department). Selectors attribute value to

innovations based on their preferences, which suggests that it is useful to define the importance of an

innovation in terms of the relationship between the innovation and the selection system, the selectors

and their preferences(Wijnberg, 2004). In other words, the importance of an innovation can

be defined by looking at how the set of selectors is composed and what the characteristics of

the selection system itself are (Wijnberg, 2004). Based on what these authors suggest it may

be concluded that in the selection process of innovations considerable attention has to be paid

to the different actors and their relationship with the innovator. Stakeholder theory helps to

identify those who can affect the organization (Freeman & McVea, 2001), and agency theory

seeks to understand the causes and consequences of goal disagreement in relationships that

organizations have (Barney & Hesterly, 1996). Both theories add an additional view to the

selection of innovations by focusing attention on the social side of innovations of which

McKelvey (1996) also suggested it to be an important aspect of the selection process. Both

theories will first be introduced separately, next will be identified how both theories can be

combined and what the implications for the selection of financial innovations are.

Which actors are present in the selection environment?

When banks understand how they affect the stakeholders that form their selection

environment, they can learn how they should respond to them (Rowley, 1997). In order to

ensure the long-term success of a bank, it is needed to manage these relationships by

integrating the interests of stakeholders in their innovations (Freeman & McVea, 2001).


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Rowley (1997) suggests that relationships are not dyadic between banks and stakeholders, but

that networks arise between stakeholders. The stakeholder network for banks exists of the

following stakeholders: consumers, suppliers, community, media, shareholders, employees,

competitors, governments, regulators, supervisors, nongovernmental organizations (NGOs)

(Hawkins Strategies Group, 2007). The influence that these stakeholders have on the selection

of financial innovations may differ per category and stage, as was also identified in paragraph

3.2. The different stakeholders can be arranged under one of the three dimensions of the

selection environment: Market, Institutions and Knowledge (McKelvey, 2001). Employees,

consumers, suppliers, competitors and shareholders are stakeholders that belong to the Market

dimension. The stakeholders that belong to the Institutional dimension are governments,

regulators, supervisors, community, media and NGOs. All stakeholders influence the

Knowledge dimension, because each stakeholder has some kind of knowledge and this

influences the selection process, however also the lack of knowledge can influence the

selection process. The identification of stakeholders helps a bank in the process of creating

financial innovations that fit with the demands of those that form the selection environment.

Shown is that stakeholder theory helps to indentify stakeholders that are involved in the

innovation and selection process, it also pays attention to the needed interaction with and

anticipation on stakeholders (Freeman & McVea, 2001).

How can the relationship between a bank and their stakeholders be explained?

When a principal (stakeholder) delegates authority to an agent (bank) and the choices of the

latter affect the welfare of the former, a so called agency relationship arises (Eisenhardt,

1989). Originally agency theory focused on the relationship between managers (agents) and

shareholders (principals), more recently it has also been applied to relationships between other

stakeholders of an organization (Barney & Hesterly, 2006). The delegation of authority in

decision making is problematic because of the fact that interests of the principal and agent

typically diverge and that the principal cannot perfectly or costless monitor the agents actions

or acquire the information available to or possessed by the agent (Barney & Hesterly, 2006).

Agency theory assumes that humans act opportunistic and are boundedly rational, which leads

to diverse interests and information asymmetries between the actors (Eisenhardt, 1989).

Bounded rationality is the assumption that humans are rational but only limitedly so because

they have a cognitive limitation on their rationality and limited time to obtain all the

information concerning their actions (Simon, 1957). Opportunistic behavior is the concept

that humans seek to fulfill their self interest, even by deceiving others (Williamson, 1957).Arrow (1985) suggested that because of moral hazard and adverse selection agency problems


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arise, consequently principals cannot ascertain the fact that the agent makes decisions in the

principals best interest. Moral hazard is the situation in which the actions of the agent are

hidden for the principal or too costly to monitor (Arrow, 1985). Adverse selection occurs

when the agent possesses information that is unobservable or too costly to obtain for the

principal (Arrow, 1985). Barney & Hesterly (1996) state that monitoring and bonding can

solve agency problems. Principals can monitor the agents behavior or the consequences of

this behavior, instead of monitoring actions or decisions a principal can also monitor the

performance implications of the agents actions, suggested is that this is also more efficient at

not highly programmable tasks, such as innovation (Barney & Hesterly, 1996). Bonding is

used to assure that both the principal, as the agent act according to each others best interest,

bonuses for managers are such an example of bonding (Barney & Hesterly, 1996).

Agency relationships in the selection environment for financial innovations arise because

often authority is delegated from stakeholders to a bank. Stakeholders want that the bank acts

in their best interest. This can be consumers who trust their money to a bank or a NGO that

wants that a bank invests according to their vision. Because there is a delegation of authority

diverse interests may be present that influence the selection process. An example is a bank

that sells a product that is not the best solution for the customer, but with which a bank will

earn more profit. Customers (stakeholders) accept these consequences because of the fact that

information asymmetries that exist and that is too difficult or costly for them to monitor the

bank.

The role of actors in the selection environment

Evolutionary economics states that suboptimal behavior is very good possible, not only

because of the fact that organizations make mistakes, but also as a result of external pressures

from stakeholders (Boschma, Frenken, & Lambooy, 2002). Stakeholders that place a claim on

the firm create an unavoidable agency conflict, because these claims reduce the amount of

resources that a bank can use for the pursuit of other goals (Hills & Jones, 1992). An

important difference between the two theories is the fact that in agency theory principals hire

agents to act on their behalf, but stakeholders other than stockholders on the other hand do not

hire managers, for employees as stakeholders even the opposite is true, they are hired by the

agent (Hills & Jones, 1992). Because banks are able to filter or distort the information they

provide to their stakeholders, gathering more information and analyzing it becomes often too

time consuming or costly for individual stakeholders (Hill & Jones, 1992). As a response to

this monitoring problem institutional structures are formed around specific stakeholders, suchas legislations by supervisors and regulators, financial information by credit rating agencies,


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and labor conditions by labor unions, because of their size these groups of stakeholders are

able to spread the monitoring costs amongst their members (Hills & Jones, 1992). To assure

that the goals of the stakeholders are being met, enforcement mechanisms such as regulations

exist, but also the threat of exit, such as shareholders selling their shares or customers buying

products of competitors helps to assure that the stakeholders interests are being served (Hills

& Jones, 1992).

To illustrate how stakeholders and their relationship with banks influence the selection

process of financial innovations, an example of the influence of each stakeholder will be

given. Market: Consumers can or cannot buy certain innovations introduced by banks.

Suppliers influence the development of financial innovations by their cooperation.

Shareholders can influence the strategy of a bank because of their ownership of the bank.

Employees can withhold or not receive information from the management of a bank.

Competitors can focus on the same niches in the market as the bank in order to gain market

share. Institutions: the Community may influence the behavior of banks regarding the bonus

structure for the management. Media can have a large impact on the image of banks.

Governments create legislations and regulations that affect the way in which banks can

conduct business. Supervisors check if banks obey the regulations set for them. NGOs focus

on influencing specific topics e.g. environmental issues, such as influencing a banks decision

to invest in nuclear power.

The effect of selection on the quality of financial innovations.

The importance of the actors in the selection environment is that they help in filtering out the

bad from the good financial innovations introduced by Dutch banks. Financial innovations

have some undeniable positive effects, which is seen in the market by the free flow and wide

distribution of information around the world (Bookstaber, 2007). The positive effects come at

the price of increased complexity, for many financial innovations it is difficult to know how

they will react in changing market conditions (Bookstaber, 2007). A clear distinction is made

between good and bad innovations, as is represented in figure 2. The figure shows the

three dimensions and the hole in the middle represents the black spot of the selection

environment. Normally only good innovations will pass, however sometimes a bad

innovation will slip through. Another possibility which may be considered is that when a

good innovation turns into a bad innovation or the other way around , thus the intention of

an innovation was good, only it was exploited in another way than intended (Koberg et al.,

1996). Concerning financial innovations, bad innovations can be described as those that


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negatively affect consumers and thus are not in line with the definition of Perelman 2 (2007)

(e.g. subprime mortgages). An example of a good financial innovation is electronic banking,

offering consumers access to their financial products at any given time and place (Van der

Velde, et al., 2004). The concept of how bad and good financial innovations pass through

selection barriers in the environment is represented in figure 2. It show two arrows, each

representing Good and Bad innovations that pass by the three dimensions that form the

selection environment for financial innovations.

Figure 2: Good and bad innovations

Although the definition may be obvious, two examples will be given to identify both a good

and a bad innovation. Good innovations are: human centered and consists of three elements:

1. Hippocratic do no harm, 2. Progressive net social benefit [(benefits -costs) > 0] and 3.

Satisficingpretty good and socially acceptable (Perelman, 2007). Bad innovations are: the

opposite of good innovations, such as computer viruses that are used for computer related

attacks by cybercriminals (Bagchi & Udo, 2003).

Definition 1: Good versus bad innovations

This paragraph has introduced the reader to the actors in the selection environment, how the

relationship between these actors can be explained, what the role of these actors is and how

they affected the selection of financial innovations. In the next paragraph an elaboration will

be given on the practical application of how the three dimensions influences the selection

process.

2 See definition 1

Good innovation selected

Bad innovation selected

Market dimension

Knowledge dimension

Institutional dimension

Selection environment


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3.4 A practical application of the selection environment

The preceding paragraphs focused solely on the literature concerning the selection of financial

innovations and the actors involved. This paragraph will add practical implications of the

three dimensions to that. In order to see what current literature stated about these threedimensions, many reliable sources such as academic literature, news papers and other

research reports were used. This lead to the identification of 13 elements of influence that

were tested with help of 13 hypotheses. These hypotheses represent each an element that has

had an influence on the start of the financial crisis according to the used sources. The topics

identified for each of the three dimensions therefore give a preliminary explanation of how

bad financial innovations passed by selection barriers in the environment.

3.4.1 Market dimensionThe market is seen as the natural place where relations are created and maintained and where

prices and volumes provide information and feedback about market transactions and

profitability to organizations (Lambooy, 2004; McKelvey, 1996). It is thus an important

dimension in the selection environment for financial innovations. The focus in this paragraph

will be on how the supply and demand side of the market influence the selection of financial

innovations.

SupplyThe Netherlands has one of the worlds most concentrated banking sectors according to the

OECD (2007). Three large players (ABN Amro, ING, Rabobank) form this high

concentration, besides them only a few seemingly smaller banks form the competitive fringe.

The incentive of competition is that organizations innovate to stay competitive on the market

and thus optimize their products and processes. Innovation theory suggests that innovations

improve when there is more competition (Aghion, et al, 2005). Because of the fact banks lack

the incentive that high competition creates, suggested is that because of the high concentration

on the Dutch markets for banks, the financial innovations introduced by banks are not as

optimized as they could be (Boot & Schinkel, 2007). A reply sometimes heard is that financial

organizations can become too big to fail, ING is such an example, it was given as a condition

for receiving support of the Dutch government that they had to sell their global insurance

operations, investment management branch and its U.S. online bank to down size their

organizations (KPMG, 2009d). It also indicates another negative effect put forward by the

increasing size of large banks. The increasing size of banks resulted in limited competition

between banks and thus the impact of these large banks on the market increased proportional.


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h1a: The financial crisis is a result of the low level of competition between Dutch banks

In the years before the financial crisis banks introduced many products in order to serve

consumers and create additional profits. The Wall Street Journal dedicated 651 articles to

financial innovations brought to the market3 between 1990 and 2002, the following tables

show the most common innovations types, the innovators and the number of innovations per

year (Lerner, 2006).

Innovation types % Organization types %

Security underwriting; trading 33.5 Security brokers & dealers 23.5

Asset management; pensions 26.2 Commercial banks 22.3

Combination of classes; other 17.7 Other nondepository credit institutions. 8.2

Retail/mortgage banking 11.6 Fire, marine & casualty insurance 2.1

Credit card 5.2 Life insurance 1.8

Insurance 5.2 Services w/ securities exchange 1.5

Commercial banking 0.6 Other non financial organizations 40.6

Table 6: Innovation types (Lerner, 2006) Table 7: Organization types (Lerner, 2006)

1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002

48 61 47 49 38 29 34 54 49 55 74 55 58

Table 8: Number of innovations per year (Lerner, 2006)

Some interesting phenomena can be identified from the research done by Lerner (2006), seen

in table 8 is that the growth of innovations peaked in 2000, the year before the dot-com

bubble bursted. In table 6 is shown that not all of the financial innovations were directly

related to offerings intended for private consumers, but mainly for business consumers. Seenin table 7 is that commercial banks and security brokers introduced the most financial

innovations. Over the years certain peaks arose in the number of financial innovations

introduced, probably this effect was reinforced as a result of high competition on the

international market. Competition and commercial interests go hand in hand, although this

may create a situation in which banks innovate solely to compete. According to Alan

Greenspan nationalization is the only option for commercial banks to regain the trust they lost

as a result of the faults they made by introducing and trading with certain financial

innovations. (Stam & Olivier, 2009). Nationalized banks do not have to deal with competition

in the same way as commercial banks do, they do not have shareholders demanding more

profit, instead they can rely on the assets of the government. The OECD (2007) mentions that

in the popular view restrictions on competition would improve the profitability of banks,

reduce failure rates and therefore safeguard stability. Suggested is that with no commercial

banks acting on the market, no incentive is present for financial innovations and without any

3Based on all articles in the Wall Street Journal between 1990 and 2002 that relate to new financial products,services, or institutions, these are verified by the Patent and Trademark Offices online database (Lerner, 2006).


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financial innovations there would never have been a crisis as there currently is (Stam &

Olivier, 2009).

h1b: The financial crisis is a result of the commercial nature of banks

Were banks as careful and selective in the transactions they brought to the market before the

financial crisis as they currently are, questions Ernst & Young (2009a). The report by

commission De Wit (2010) concluded the following: In the last 10 to 15 years creating

shareholder value became gradually the number one priority within in publicly traded banks.

This lead to more focus on increasing short-term profits to create a high return for

shareholders. Focusing on only shareholders, lead to a situation in which other stakeholders

received less attention. Generating additional profits was done by focusing more on

investment banking activities such as trading, mediation and giving advice besides traditional

consumer banking such as savings and loans (Ernst & Young, 2009b). Banks also had more

instruments at their hands to innovate, such as securitization in order to transfer the risks of

certain products. An important difference between investment banking and consumer banking

is that the former is much more transaction focused and therefore dares to take big risks in

favor of high returns (KPMG, 2009b). Investment bankers are used to high rewards as

compensation for their high job uncertainty. While consumer banking is more relationship

oriented and thus more stable, this created an unbalance within banks that combined both

activities on a large scale (Ernst & Young, 2010b). Also the management of Dutch banks

accepted these tendencies, on one side they were driven by the need to create more

shareholder value, but parallel to that was the fact that their own compensation also depended

on the banks performance. These diverse interests within a bank also influenced the

unbalance, this created a situation in which banks wanted to increase profits with a minimum

of capital. So had public traded banks (ING, ABN Amro) on average 10 percent more return

on their net assets than a private owned bank (Rabobank). This may well suggest that these

public traded banks because of the fact they had sufficient capital to bear possible negative

financial results were less critical towards financial innovations and the accompanying risks

in the years before the crisis. This suggestion is supported by another conclusion from

commission De Wit (2010), in the board of banks the Chief Financial Officer (CFO) often

also acts as the Chief Risk Officer (CRO). The CRO is in an organization responsible for

guarding the operational and financial risks. In banks without a CRO a possible conflict of

interest between the risk monitoring task of a CFO and the need to increase profits with

minimal capital.KPMG (2009b) states that banks were well-known with the unbalance in the


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banking system and its risks, only that they failed to turn this knowledge into risk mitigating

actions.

h1c: The financial crisis is a result of the fact that the management of banks failed to find the

balance between commercial stakes and the accompanying risks

The Dutch minister of finance, Jan-Kees de Jager said on a meeting about financial

innovations (Spelier, 2010): Innovation is the driving force behind economic growth and therefore

it is necessary. But renewal is not always an improvement. Complex products and processes are often

not understandable. Complex mathematical formulas are used and common sense lacks sometimes.

Innovations are important, but we should not lose sight of the consequences for the environment.

The interconnectedness between being a supplier and a consumer may create another

complexity in the relationship between a bank and its stakeholders, this may lead to diverse

interests. The supply side of the market namely consists of two types of suppliers, there are

financial organizations that offer products to the market, but there are also consumers that

create a supply by offering their capital to banks in the form of deposits and savings. Creating

awareness, support for and understanding of financial innovations amongst consumers is

therefore needed. The OECD (2005) suggests that financial organizations should be

encouraged to clearly distinguish between financial education, financial information and

commercial financial advice. Any financial advice for business purposes should be

transparent and disclose clearly the commercial nature if it is also promoted as financial

education. Financial organizations should be encouraged to check that the information

provided to their customers is read and understood. The debate on the complexity and the

unclearness of financial innovations is currently ongoing and will probably continue. The

ambiguity in the supply side of the market and the task a bank has to make unclear and

complex financial innovation understandable, identifies some of the difficulties that surround

financial innovations.

h1d: The financial crisis is a result of the fact that financial innovations were unclear andcomplex

Demand

Besides supply, markets also rely on the demand of consumers. While financial innovations

were also introduced before the 1990s, it was accelerated from then on by a consumer demand

that accepted the complexity and risks of financial innovations (Kalse & Van Lent, 2009).

Shiller (2009) suggested that subprime mortgages were such a demand, while it offered both

benefits as risks for the consumer. Subprime mortgages offered consumers with a low income

the possibility to buy a home, but the variable interest rate created a major risk. This conflict


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of interest in demand can be explained by consumer greed at the time. A seemingly

information asymmetry existed between banks and consumers, such as the risks of a subprime

mortgage. Probably, consumers accepted this because of the fact that it was too difficult for

them to oversee the risks as a result of monitoring costs that were too high. In the period from

1990 onwards household debts increased from 108 billion to 680 billion in 2007 . This

tendency can even be traced back to the period following the Second World War that initiated

mass consumption and the need to borrow money to keep the economy going (Kalse & Van

Lent, 2009). This suggests that consumers accept certain risks when they expect possible

profits, this risk appetite is influenced by the greed that some consumers have.

h1e: The financial crisis is a result of the greed of consumers

Consumers are often not only customer, but they are also partner by supplying capital, authors

such as Andrews (2007), Mohen, et al. (2008) and Drew (1995) identified the need of

involving consumers in order to create new demand. The involvement of stakeholders may

reduce bonding costs because of the fact that information asymmetries are minimized. Naud,

Blackman & Dengeler (1999) identified that creating access to a large customer base by

looking at potential suitable customers, receiving feedback from them and responding in time

to their requests is needed to create and identify market demand. Iammarino, Sanna

Randaccio & Savona (2007) added to this that missing or insufficient information on market

demand such as the lack of consumer responsiveness negatively influences the success of

innovations on the market. Thwaites (1999) concluded that the analysis of buyer behavior and

an understanding of consumer needs are essential in identifying market demand. Banks need

to know and understand what consumers demand in order to offer them the service they need.

41% of the customers of Dutch banks see trust as the major reason why they would switch to

another bank, 37% indicated that service and 31% that price are other important factors on

which they value their bank (Ernst & Young, 2010b). KPMG (2009d) identified regulatory

demands as the driving factor within banks for changing their business models, this suggests

that the demand of consumers is not the main driver for change at banks. One of the

tendencies of the last years is that banks try to replace face-to-face customer contact by

focusing on channels such as internet and telephone, however shown is that 60 percent of the

customers demand that services have to be improved at banks (Ernst & Young, 2010b). 40

percent of the customers indicated that they are not satisfied with their current bank (Ernst &

Young, 2010b). Thwaites (1999) also concluded that there is a need for an attitudinal change

within financial organizations as a result of increasing complexity and dynamics in demand.h1f: The financial crisis is a result of the lack of consumer involvement


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The following issues were identified in this subparagraph on the market dimension of the

selection environment: for the supply side, the level of competition between banks, their

commercial nature, the balance between commerce and risk, the unclearness and complexity

of financial innovations and for the demand side, the greed of consumers and the lack of

consumer involvement. This elaboration on how supply and demand act as selection

mechanisms in the market raises the question of how do institutions act when financial

innovations are developed and introduced to the market. The next subparagraph will deal with

this question by looking at the institutions that are involved and which role they have in the

process.

3.4.2 Institutional dimension

The concept of institutions can be defined as a system of rules and sanctions, acting as a

framework in which markets operate (McKelvey, 2001). In this research the focus will be on

laws, regulations, and policies imposed by the Dutch government that are enforced by

authorities such as De Nederlansche Bank (DNB, Dutch central bank) and the Autoriteit

Financile Markten (AFM, supervision financial organizations). The institutional environment

that we focus on here clearly represents a group of stakeholders that has banks as their agents.

Markets are complex and dynamic, especially where financial innovation is in play, as a result

the task of the regulator will always be extremely difficult was stated by KPMG (2010).

Legislative requirements and regulations indirectly influence the innovation process (Hewit-

Dundas, 2006; Mohen, et al., 2008). The OECD (2007) points outs to a possible trade-off

between prudential regulations and the competitiveness of the banking industry, because

prudential practices might unnecessarily constrain competitiveness. Because of the high

concentration of banks in the Netherlands, regulatory and supervisory practices are often

developed in consultation with the banks. In addition Iammarino, SannaRandaccio & Savona

(2007) concluded that insufficient flexibility in regulations will negatively influence

innovations. The banking crisis has exposed weaknesses in regulations and in the underlying

frameworks, but also the implementation and policing showed some deficiencies (Ernst &

Young, 2009a).The crisis indicated that regulatory screws were too loose concerning capital

and liquidity ratios in order to protect consumers (Ernst & Young, 2009a). The years before

the crisis were from a regulators point of view not the Wild West, there were many laws and


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regulations applicable for financial organizations that influenced their innovations. The laws

and regulations that apply to Dutch banks were summarized by Van der Velde, et al. (2004):

Laws and regulations Basel II (Stability controls for banks) WFT (Law financial supervision)

IFRS (Internal Finance and Reporting Standards) MOT (Reporting unusual transactions)

IAS (International Accounting Standards) Financile Bijsluiter (Financial notice)

WID (Law identification for services) Zorgplicht (Duty of well care)

Wed (Law on economic crimes)

Table 9: Laws and regulations (Van de Velde, et al, 2004)Although there are many laws and regulations on how banks are supposed to act and treat

their customers, only Basel II imposes more demand of capital when a new product is

introduced or when the risks are larger and not clearly identified (Van der Velde, et al., 2004).

Capital demands were seen by regulators as the main instrument to control financialorganizations (Kalse & Van Lent, 2009). In September 2007 the International Monetary Fund

(IMF) suggested that the financial crisis was possibly caused as a result of the use of systems

which had as goal to minimize risks, which identifies a counterproductive effect of the solely

instrumental character of regulations. To find the regulative issues that were of influence on

the start of the financial crisis the Dutch government formed a research commission that

identified, 1. that there was a lack of supervision (too little steering by the DNB and AFM), 2.

that the government lacked complete insight on the negative macroeconomic developments

and the effects on the financial system and 3. that capital requirements were too low (De Wit,

2010). However, none of the recommendations by Commission De Wit (2010) focused

directly on financial innovations. This suggests that the existing regulations before the crisis

were not adequate enough to guard the risks of financial innovations. It is therefore important

for regulators and supervisor to focus on monitoring banks even more, but this focus has to be

on the right aspects.

h2a: The financial crisis is a result of failing regulations

The level playing field of the financial services sector is for a large part supranational and

even global. This improved the efficiency of transferring capital across the globe, but it also

caused that problems also easily transferred from the U.S. to Europe (De Wit, 2010).

European regulations influence local regulations, member countries are obligated to

incorporate these in national legislations and regulations (OECD, 2007). An international

operating bank has to deal therefore besides with national, also with international laws and

regulations (KPMG, 2010). In Europe the European Central Bank (ECB) and the European

Systematic Risk Board (ESRB) are responsible for guarding financial stability on a macro


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level for all members of the European Union (Ernst & Young, 2009b). One of the

consequences is that national central banks and governments have to accept that the

responsibility for large international banks lays outside their control, therefore the need for a

one level playing field favors a two track policy of national and international regulations.

(Ernst & Young, 2009b; KPMG, 2009b). Between the group of institutional stakeholders

another agency relationship can be identified, European regulators act as principals of local

regulators who act as agents of them, possible information asymmetries between them should

be minimized in order to create a one level playing field. With the international aspect of

financial innovations in mind and the existence of the current financial crisis it is assumed that

the existing international regulations were inadequate.

h2b: The financial crisis is a result of too few international regulations

One of the changes in regulations is the improvement of Basel II, Basel III focuses on an

increase in loss absorption, better quality, more quantity, better risk weights and the

introduction of a leverage ratio for banks (DNB, 2010). This indicates that not only

monitoring, but also bonding becomes important, while it demands that banks become even

more involved than they already are in guarding the risks by reserving more capital. A report

by Ernst & Young (2009b) suggested that increasing engagement with regulators is needed.

More and intensive communication between regulators and banks helps to offer a solution for

this problem. The DNB advocates the need for more intervention, authorizations and tighter

frameworks, because in the past banks have gotten too much space to innovate, globalize and

acquire (KPMG, 2010). One of the issues related to this was pointed out by KPMG (2010),

rules and regulations are always one step behind of the market and are always reactive on new

market behavior. The president of the DNB Wout Nellink stated: There are times in which

innovations are introduced in such a pace that it is impossible to keep up. (Kalse & Van

Lent, 2009). Self regulation is already assumed in the principle based supervision that applies

to banks in the Netherlands. The opposite, rules based supervision is suggested to be

ineffective in the end, because it will lead to false securities and hiding behavior, the goal has

to be to introduce triggers which increase the insights and feeling of responsibilities at banks

to act prudent (KPMG, 2009b). However, Ram Mohan (2007) suggests that principle based

supervision makes it unclear for financial organizations what provokes intervention by

regulators. So does a rules-based regime tell everyone what is required to enter a field and

compete, a principle based regime is open to

verhagen, n. (2011). survival of the fittest, not only the best survive - an explorative research on...

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