Who are the innovators behind the fintech boom? Despite the intense interest in financial innovations and their consequences, we know remarkably little about how and where these new products and services are developed. Our recent work [“Financial Innovation in the 21st Century: Evidence from U.S. Patents”] with Nick Short and Yuan Sun seeks to address this gap using a newly constructed dataset of more than 24,000 financial US patent applications between 2000 and 2018.
For most of the 20th century, patents provided only a limited guide to innovative activity in finance. Between 1971 and 2000, the US patent office issued just 445 financial patents, less than 0.02% of all awards. Firms were reluctant to incur the time and expense to file for patents, allowing new product ideas to diffuse rapidly across competitors. This is partly because, in contrast to other sectors, there has long been ambiguity about financial innovators’ ability to appropriate their discoveries. Following a 1908 US court decision that established a “business methods exception”, many judges and lawyers presumed that business methods were not patentable. It has also been very difficult for firms to detect infringement of patents related to valuation and trading.
Attitudes changed with the July 1998 decision in State Street Bank and Trust v. Signature Financial Group. State Street Bank challenged the validity of Signature’s patent on a software program used to determine the value of mutual funds, claiming it covered a business method. The Court of Appeals for the Federal Circuit affirmed the patentability of the software since it produced a “useful, concrete, and tangible result”. Numerous trade press articles interpreted the case as unambiguously establishing that business methods are just as patentable as more traditional technologies. Conversations with patent practitioners suggest that the historical differences between patenting in finance and in other technological domains have narrowed considerably in recent decades. Similar changing attitudes have been seen in Japan and other nations.
Dramatic Rise of Financial Patents
Identifying finance-related patent filings remains a challenge. We first identify a set of patents that are assigned to financial patent classes, then use the patent text and inventors’ names to train a natural-language processing model to recognize similar financial innovations that might be assigned elsewhere. This allows us to analyze financial patents in a wide range of patent classes.
Figure 1 illustrates the dramatic boost in financial patent applications and awards over this period, from a nearly infinitesimal share to between 0.4% and 1.1% of all grants. Financial patents are also disproportionately important, according to commonly used measures of patent value. The patenting patterns closely reflect those seen when we use another measure for innovative expenditures (corporate venture capital investments) and do not appear to be driven by shifts in reliance on trade secrets.
We also show that an increasing fraction of patented financial innovations focus on consumer rather than business applications. In addition, the surge in financial patenting is driven by US information technology (IT) firms and in sectors other than finance. Banks and other financial institutions represent a modest share of the awards, which are dominated by IT companies. Banks and payments firms increasingly focus on their core areas, while IT firms and other financial firms have continued to patent widely in finance. IT, payments, and other firms are more likely to be issued process patents, as well as consumer finance ones.
“An increasing fraction of patented financial innovations focus on consumer rather than business applications. In addition, the surge in financial patenting is driven by US information technology firms and in sectors other than finance.”
The share of US awardees relative to foreign firms is growing. Within the US, we see the rise of innovation in the greater San Francisco region (and the Pacific more generally) and the decline of the New York area.
Relocation to Escape Regulation
Financial regulatory actions seem to have adversely affected innovation by financial firms. In the years after the global financial crisis (GFC), financial innovation by banks shifted to locations with looser financial regulation. More speculatively, these results suggest that the seeming failure of banks and other financial institutions to expand their innovative scope may have (at least partially) been due to pressures from financial regulators. As well as pushing financial incumbents to relocate innovative activities, regulation may have depressed their focus on innovation more generally.
By contrast, regions with the highest technological opportunities in general attracted financial innovation by payments, IT, and other non-financial firms. Overall, the evidence is consistent with two sets of explanations for relocated innovation: the push of regulatory pressures and the pull of technological opportunity.
Where Do the Ideas Come From?
To examine the source of the ideas behind finance patents, we explore the relationship between financial innovations and the academic knowledge base. Over the sample period, academic citations (references) in finance patents were associated with more impactful patents. This effect also held for citations to articles in business, economics, and finance journals specifically. Over time, the relationship between academic citations and patent value grew stronger (particularly from 2015 to 2018). However, the number of academic citations in finance patents fell. This decline was most dramatic for banks, and for citations to business, economics, and finance journals. Citations have been to increasingly older academic articles.
“After the 2008 crisis, financial innovation by banks shifted to locations with looser financial regulation… By contrast, regions with the highest technological opportunities attracted innovation by payments, IT, and other non-financial firms.”
Three explanations can be offered for the patterns of fewer but more valuable academic references. First, as the focus of financial patents shifted from business to consumer applications, there may have been less relevant academic work. Second, commercially relevant academic discoveries in finance may be harder to come by. Finally, financial organizations, especially banks, may struggle to absorb insights associated with consumer-oriented patents.
Implications for Policymakers and Business Leaders
The failure of traditional financial institutions to maintain pace in consumer-focused innovation is puzzling. The results hint at factors that may have exacerbated the declining share of financial innovation by banks: the seeming decrease in relevant contemporaneous academic discoveries (or the ability to identify and absorb them), as well as regulatory pressures after the GFC.
If financial and consumer-oriented innovation is seen as desirable, it should be protected and encouraged. When tightening financial regulation, government leaders must therefore factor in the unintended effects on innovation. This recommendation is challenging to implement given that the nature and consequences of a financial innovation – unlike, say, a new semiconductor or cancer therapy – can be difficult to anticipate. Moreover, regulation is often arranged by institution and, as we have shown, financial innovations often arrive from outside the finance industry.
Our findings also suggest the need for financial incumbents to intensively explore alternative ways to access knowledge about innovations emerging from the IT sector. Among the important avenues are alliances, corporate venture capital, and acquisitions. Making sure these efforts are appropriately structured will be critical.
- Offering a window on the fintech boom, financial patents have risen dramatically since 1998.
- The surge in financial innovation is driven by IT firms in the US, focused on consumer rather than business applications. Banks and traditional financial institutions have been left behind.
- Academic citations in finance patents have been falling in number, but growing in value.
- Policymakers should note that financial innovation has shifted to locations with looser regulation and higher technological opportunities.
The preceding is republished on TAP with permission by its author, Professor Josh Lerner and by the Toulouse Network for Information Technology (TNIT). “Where Are the Fintech Innovators?” was originally published in TNIT’s February 2022 newsletter.
Josh Lerner is the Jacob H. Schiff Professor of Investment Banking at Harvard Business School and head of the Entrepreneurial Management unit. Much of his research focuses on the structure and role of venture capital and private equity organizations. He also examines policies on innovation and how they impact firm strategies.
Amit Seru is the Steven and Roberta Denning Professor of Finance at Stanford's Graduate School of Business. His research focuses on corporate finance with an emphasis on financial intermediation and regulation, technological innovation and incentive provision, and financing in firms.