How Barack Obama inspired my 3 books on banking innovation

I was recently asked what inspired me to write 3 books in 3 years, focused on 3 perspectives of what innovation means in financial services. The core of this trilogy is the industry transformation from transactions (revenues from products) to services (packaging of products into advisory mechanisms), which would require a threefold change of pace:

• money management, thus let clients' goals take centre stage;
• financial technology, thus transform financial advice with knowledge digitisation;
• business models, thus change banks and adhere to the spirit of new regulations.

Although these books where published in 2015, 2016 and 2017 during my work for IBM Industry Academy, I conceived this corpus a few years back when my former risk management boss, then commissioner of Italian regulator CONSOB, called me one morning saying:

"Have you heard what the US President said at the White House yesterday? Isn't this what you've always been preaching about?"

Indeed, my literary journey was inspired by the US President speech at the White House ... I said speech and not tweet, so I refer to US President Barack Obama.

Author's note: No politics intended, pls. This is not and doesn't want to be a political article. I have great respect for all opposing political opinions of US electorate.

How did Barack Obama do it? This little story will take us back though time, on a journey to the “beginning of the end” that is the Global Financial Crisis (GFC). I had been for a decade head of quantitative risk management for investment banks, and I had found myself pondering on the unbalanced state of financial markets, and the amount of financial innovation (structured products and credit derivatives of all sorts) which had forced the industry to lose gravity among clients' needs, risky dynamics of financial markets and transaction costs.

When I left the Italian bank in 2008, to create a wealth management startup in Germany, the crisis just burst and I thought there would be no better time to be innovative: regulations would be ultimately more demanding, markets would be accessed in new ways, clients would have different expectations ... clearly an opportunity for industry change.

We are now in 2009, Lehman Brothers already filed for bankruptcy, many US families had to face painful foreclosures of residential mortgages which prompted unprecedented public outcry. Regulators and policymakers where overwhelmingly asked to intervene. US President Barack Obama declared some key principles to rewire banking, in his remarks after a regulatory reform meeting at the White House. He said (read full speech here):

 "We need strong and uniform supervision of financial products marketed to investors and consumers. And we should base this oversight not on abstract models created by the institutions themselves, but on actual data on how actual people make financial decisions." - Barack Obama

To me, this boiled down to 3 concept: actual data, actual clients and actual decision-making.

First book: actual data

Actual data means that final investors don't buy asset classes (notwithstanding what we find inside many advisory reports), but real products (eg. bonds, structured notes, formula funds) which come with payoffs linked to specific costs and charges. The price dynamics of these real products are linked to the change of financial variables over time (eg. the term structure interest rates). Therefore, the first innovation would be to upgrade Modern Portfolio Theory and adopt probabilistic scenarios based on full revaluation over time of real securities.

For those who don't have any clue about what probability theory is, or derivatives pricing means, we can see it this way: if your financial advisor helps you to buy oranges (eg. subordinated bonds) but sells them to you as if they are lemons (eg. asset classes, benchmarks), the result is that you pay for a sweet organ juice but you end up drinking a bitter lemonade. Recent European regulations (PRIPPS and MiFID II) are enforcing higher transparency on costs and charges, thus ask to link real products to the potential benefits they want to generate, and force comparison upon cheaper alternatives. Therefore, banks would benefit from upgrading their financial engines at the level of the distribution channels, the way described in my first book "Modern Portfolio Management: from Markowitz to Probabilistic Scenario Optimisation" (RiskBooks, 2015). While reporting has to be "simple", the engines underneath need to be fit for purpose, so that manufactures and distributors can work on same actual data (PRIIPS and MiFID II combined).

Second book: actual clients

Clearly, we are all more and more digital beings and Fintech startups are demonstrating the possibility to disintermediate banking relationships by using digital technology. However, Silicon Valley misunderstands how banking works and that final clients operate inside a push mechanism when it comes to investment management, while digital is a pull technology.

Just think about it: nobody goes on Amazon to see what is going on, but with a purpose such as buying one of my books and then settling for a different title, because Amazon Ai-driven algorithm pushes a complimentary purchase. Essentially, most of our consumption habits start with "a purpose". Instead, when it comes to investing very few retail clients would start with a purpose: actual clients start with "open questions" such as "I have some money left, what shall I do?". This is the reason why pushing financial products doesn't work well on digital: clients search for answers not products. How to solve the problem, while willing to invest on digital platforms? There are two ways to address the pull/push gap:

• marketing narrative shall change from product focus to client centricity (eg. goals like retirement, house, education);
• hybrid models are the main choice to grow to optimise branding costs, until Artificial Intelligence becomes truly conversational and turns digital from push to pull (voice is the new marketing).

This is why the subtitle of my second bestseller "Fintech Innovation" (Wiley, 2016) is "From Robo-Advisors to Goal Based Investing and Gamification".

Third book: actual decision-making

Finally, how do clients make decisions? Many clients mistakingly think to pay advisors to buy products which convey performance (alpha marketing), while they truly buy products to access an exposure to risk (nobody owns the future). While banks are fully aware of this cognitive bias, which is the basis of the asymmetry of information that has shaped an offering driven industry for decades (push mechanism), the real problem is that clients would have a hard time in understanding risk-based conversations due to their cognitive biases and greed.

The post-truth is that, what actual clients truly buy are not even products, but comfort to make financial decisions. This comfort is a fiduciary element, which is forged through a conversation. Therefore, fiduciary standards are core of all new regulations (eg. DOL, MiFID II) because they attempt to "regulate" the mechanism which generate trust within a "push driven industry".

Trust about somebody else's knowledge is the essence of actual decision-making.

This is the reason for the third book "MiFID II: Value-Generation for Investors", which uses European regulation only as a canvas to discuss how new effective and added-value business models can be created (not only EU, but also US and APAC), by dividing the steps of on-boarding actual clients (wealth allocation framework) and in-boarding actual investment solutions (monte carlo scenarios applied to real products and portfolios).

Knowledge digitisation

Only by innovating in finance, technology and business models the industry of financial services can leave the conundrum of lower margins and digital disintermediation. However, the industry shall learn to use Fintech to target sustaining innovation (which means added value differentiation through knowledge digitisation) instead of disruptive innovation (which means commoditised investment solutions). Otherwise, neither banks nor innovative Fintech startups will stay relevant the day tech giant (GAFA and BAT) will enter financial services ... and it might happen sooner that we expect.

All books on Amazon, links and more on my author’s page thepsironi.com

Paolo Sironi, author and member of IBM Industry Academy, Fintech Thought Leader of IBM Watson Financial Services.