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21 January 2025

The Forces Shaping Financial Innovation

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Tag Innovation

The Forces Shaping Financial Innovation

Professor Robert C. Merton on Innovation and Financial Science

Financial innovation is not just about new ideas; it’s about addressing urgent needs. Nobel laureate Robert C. Merton explores how science, technology, and the need to tackle crises have driven financial innovations that continue to shape our world.

 

The TUM School of Management recently welcomed Professor Robert C. Merton, one of the most celebrated figures in modern financial economics, for an extraordinary evening that bridged the worlds of academia and practice. With profound insights into the evolution of financial science, Prof. Merton inspired the audience to rethink possibilities in finance.

 

A Legacy of Innovation

Prof. Merton, awarded the 1997 Nobel Prize in Economic Sciences for his groundbreaking work on the Black-Scholes-Merton model, emphasized the combination of science, technology, and need as the driving forces of innovation. His reflections on financial evolution highlighted the critical role of these elements in addressing real-world challenges and fostering meaningful progress.

 

Prof. Merton shared his expertise in an exclusive interview, offering his views on the driving forces of financial innovation and the role of technology and human ingenuity in shaping the future.

 

Professor Merton, what drives financial innovation?

 

Professor Merton:

“Financial innovation is driven by three things. Science, which helps us understand how finance works and provides the building blocks to financial engineering. Technology – I don’t need to explain to TUM why that’s important. And need: if there’s no need for innovation, it just doesn’t happen.

 

This means innovation is often most active in times of crisis, when needs are greatest. Think back to the 1970s when there were a series of financial shocks: double-digit inflation; stagflation; a 50% fall in stock markets; oil crises; the break-up of the Bretton Woods agreement which unpegged world currencies and ended a generation of global currency stability. The list goes on.

 

No one had prior experience of these events but, rather than retreat from these risks, science and technology combined to address the need, and thus innovation provided new ways to manage new risks.

 

Many of the innovations of the 1970s are taken for granted now but they all solved a problem, or helped manage a risk. Among them are: an options and futures market that provides insurance against losses in currencies, interest rates, stocks and commodities; passive mutual funds that eliminate idiosyncratic manager risk; international diversification, which reduces standard deviation and increases expected return; debt securitization, which helps organisations manage capital requirements; and many more.”

 

What scope is there for future innovation?

 

Professor Merton:

“I’m very optimistic about our capacity to continue innovation. There is no shortage of crises to act as the catalyst and the pace of innovation is accelerating. There were hundreds of years between the first bill of exchange and modern electronic banking, but technology is enabling new innovations to be introduced at a rapid rate, and at low cost.”

 

What part could AI play?

 

Professor Merton:

“I think AI will be helpful, but it needs us to operate it. I’m pretty good at mental calculations, but a $6 calculator can do them better and faster than me. Although the calculator is good, it still needs my input and my ideas. The same goes for machines like the IBM 360 which transformed our ability to do complex research in the 1960s but needed us to operate it. This is how I see AI, as a useful tool that enhances human intelligence rather than replacing it.”

 

What’s your message to aspiring financial innovators?

 

Professor Merton:

“Aim for better. Ask yourselves not what has been done, but what could be done.”

 

Prof. Merton: Nobel Laureate and Visionary

Robert C. Merton is one of the most influential figures in modern financial economics. He was honored with the Nobel Prize in Economic Sciences in 1997 for his pioneering contributions to the Black-Scholes-Merton model, a cornerstone of financial engineering that revolutionized options pricing and risk management. Prof. Merton has held prestigious academic positions, including at Harvard University and MIT, and his work extends across financial theory, retirement planning, and infrastructure finance. His enduring impact on both academia and industry continues to shape the way financial markets operate today.