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The Role of Large Barks in Financing Innovation JOHN S. REED and GLEN R. MORENO The role of majorfinar~czal institutions in stimulating technological innovation is not limited to the simple lending offends. In the broad- est sense, it lies in creating newfnancial techniques, or in innovation of financial technology. It is as innovators themselves that large financial institutions play their most decisive role irz suz'DortinQ irz- novation among their client companies. or There is growing, recognition that technological innovation is a key de- tenninant of continuing economic growth and prosperity. International at- tention has focused on the United States, where the emergence of a service economy, the rapid growth of high technology companies, and the apparent linkage between the grown of small companies and job creation offer promise of maintaining grown in the postindustrial economy. The increasing im- portance of high technology industries in Japan, where economic growth, though slower, continues, seems to offer fumier hope of a reasonably ordered transition from an economic system based on heavy industry to one centered on the emerging technologies of our times. These trends have been closely observed in Europe. There, policy initia- . . . rives to maintain economic growth and employment over the past decade are generally recognized to have failed. Policies based on maintaining employ- ment through increasing public sector interventionrigid labor practices, industry protection, and subsidies have arguably hastened, rather than de- layed, the competitive demise of the industries concerned. Thus, throughout the developed economies, there is an emerging consensus that innovation brings growth, and policymakers are increasingly seeking ways to stimulate technological innovation and new company formation. 453

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454 JOHN S. REED and GLEN R. MORENO As a subset of these broad economic policy considerations, there is a ==owing perception of the importance of national and international financial systems to the process of technological innovation and economic growth. This is most evident in the keen international interest in the venture capital phenomenon in the United States, and in the various public and private sector initiatives to emulate its successes abroad. The venture capital system, how- ever, represents only a tiny portion of the capital-formation process. It is, therefore, important to enhance the overall effectiveness of the financial system in supporting technological innovation. Our purpose in this chapter is to describe briefly the role of large banks in financing technological innovation in industry. Since there is little pub- lished material on the subject, we have of necessity relied on the collective experience of our own organization (Citibank Corporations and our inter- pretation of general trends in the global financial system. The theme that emerges quite consistently from our observations is Cat the role of major financial institutions in stimulating technological innovation is not limited to the simple lending of fiends. In the broadest sense, it lies in creating, new financial techniques, or in innovation of financial technology. It is as in- novators themselves that large financial institutions play their most decisive role in supporting innovation among Heir client companies. Financial in- novation supports technological innovation. Thus, the public interest is best served by a financial system that provides maximum scope for competition and innovation in financial services. BANKS ANI:) TECHNOLOGICAL INNOVATION It is wow noting that banks' involvement in He innovative process is not limited to their role as financial intermediaries. Technology has significantly influenced the historical development of the banking system and is a major factor for change in the financial services industry today. The historical evolution of America's large financial institutions is closely interned with the process of technological innovation in the nineteenth century. In transportation technology, He opening of the Erie Canal in 1825 and advent of the railroad in He 1830s strengthened New York's position as the coun~y's manufacturing and trading center. This, in mm, led to New York's emergence as the dominant financial center in the country. Country banks kept balances with New York banks as liquid reserves for clearing the variety of commercial transactions Hat passed Trough the city, and the New York banks soon held a major part of the total banking resources in the country. Thus, technological innovation was instrumental in creating He forerunners of the '`money center" banks 150 years ago. Citibank offers an interesting example of the historical linkage between technology and banking, for its fortunes during the nineteenth century were

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THE RO' F OF LARGE BANKS IN FINANCING INNOVATION 455 closely linked to technological innovation. The basis of the bank's wealth and influence and that of its dominant shareholders progressed from trading coal to dominating Me New York lighting utilities, whose technology was based on gas manufactured from coal. This activity led to heavy investment in the railroads that brought the coal to New York City and investment in iron manufacturing, another heavy user of coal. The bank was involved in the progress of the metallurgy industry in the United States and financed the introduction of the Bessemer steel process at the Lackawanna Iron Company. Citibank was also active in the development of communications technology; it financed Me laying of the fist transatlantic cable from 1858 to 1866 and at one point dominated the Western Union Telegraph Company, then the largest enterprise in the world. Today, the tables have been fumed and it is the financial services industry Mat finds itself dominated by the new information technologies. A recent study for Congress by Me Office of Technology Assessment described the scope of this influence: "The applications of advanced inforTnat~on and tele- communicahons technologies in systems for delivering financial services change the way those services are created, delivered, pnced, received, ac- cepted and used. " ~ It is therefore not surprising that possibly Me most direct way in which financial institutions fund innovation is as purchasers and users of infonnation technology. U.S. depository institutions spent well over $8 billion in 1984 on data processing equipment and services, excluding office automation. Commercial banks alone spent just under $5 billion on purchases of data processing equipment and services from outside vendors. Almost half of those purchases were made by the coun~y's 240 largest banks. Citicorp itself is, of course, a major user of technology-related services and equipment. Our estimated expenditures in these areas are approaching half a billion dollars a year. As users, large financial institutions are actively exploring and developing commercial applications for new technologies as they are introduced. Rapid advances in voice, facsimile, image, and graphics processing, as well as communications technologies, give rise to new commercial opportunities for accessing, manipulating, and using infonnation in financial businesses. Au- tomated teller machines, point-of-sale terminals, and home-banking networks are spreading across the United States. Many banks, including Citicorp, are building worldwide computing networks linking common databases around Me globe. Electronic trading systems and international fund-transfer networks are part of this growing international financial network. Some large financial institutions, again including Citicorp, have invested in or operate they own technology affiliates, working win other companies to develop specific hard- ware and software for application within their financial services businesses. These aggregate activities represent a significant source of concentrated

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456 JOHN S. REED and GLEN R. MORENO orders and revenue to the technology companies whose products and services are involved. hn addition, they provide a screening process in the selection of commercially viable technological innovations. At least In the field of information technology, innovation in financial services quite demonstrably supports technological innovation. THE ROLE OF LARGE BANKS IN THE F~ANCLAL SYSTEM The direct role of banks as users of technological innovation is relatively simple to describe and quantify. When viewing the broader role of banks as financial intermediaries, however, it is much more difficult to establish direct links between bank finance and technological innovation. Part of this diff~- culty lies in the nature of bank lending itself, which is designed to avoid or mitigate risks predicated on the success of a particular innovation. Bank lending by its very nature tends to finance innovation indirectly. Thus, to better understand He role of banks in financing innovation, it is useful to understand He role that banks and other financial institutions play in financing the total economy. Domestic financial institutions held total assets of over $6 tnilion in 1983. Banks and savings and loan institutions accounted for almost half of those assets, and life insurance companies and pension funds made up another quarter. Large banks held a concentrated share of those assets. Out of the nation's 14,500 banks, the roughly 240 banks with balance sheets of more than $1 billion held about 60 percent of total domestic banking assets. Clearly large banks play a very significant role in the U.S. financial system. This does not mean Hat large banks or the banking system as a whole are dominant providers of funds to American industry. In fact, bank debt is used to fund less than 10 percent of the total assets of American manufacturing companies. This reflects the importance of public bond issues, equity, internal cash generation, and trade credit in financing American enterprise. The U.S. system is quite different from some other major financial systems in this respect. In Japan banks play a much more dominant role in the supply of finance to industry. Japanese companies are much more leveraged than their U.S. counterparts, and He vast majority of Japanese borrowings is represented by bank debt, which accounts for as much as 75 to 80 percent of total external borrowings of Japanese companies. This high level of bank borrowing, combined win the system of "main bank" relationships, leads to a much more dominant role of Japanese banks in the affairs of Japanese companies. The situation in West Germany is not as pronounced as that in Japan, but German banks do play a more important role in financing enterprise Han is the case in the United States. This is due to He relatively high leverage of German companies, die German universal banking system (in which banks

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THE ROLE OF LARGE BANJOS IN FIN^ClNG INNOVATION 457 provide most sources of funding), and the house bank system (wherein one bank normally enjoys board representation and traditionally plays a leading role in the arranging of a company's financed. The British banking system provides the closest parallel to the limited role of banks in the United States. Since the Industrial Revolution, British com- panies have sought to maintain a measure of independence from the banking system by covering the bulk of their finance from internal sources. Over the last several years retained earnings accounted for 68 percent of the sources of funds of British companies, compared to only 17 percent for individual bank borrowings and less than 5 percent for United Kingdom capital market issues. In sum, large banks are a very important factorin the U.S. financial system. But even allowing for public debt underwritten by investment banks, bor- rowings through U.S. financial institutions play a somewhat limited role in financing American business, both as a percentage of total funding sources and in comparison with other major financial systems. Moreover, our ex- perience indicates that the role of large banks in financing technological innovation appears to increase in importance with company size. This may be demonstrated by examining the role of large banks in financing innovation in companies at three phases of maturity: the start-up company; the emerging growth company; and Me large, established company. LARGE BANKS AND TlIE START-UP COMPANY Banks rarely finance start-up operations directly. This prudence is essential to the effective functioning of the banking system. True start-up ventures are risky. They involve plans, hopes, and uncer- tainty. If successful, the rewards are significant. Failure can mean losing all, and failure rates are statistically high. It is thus clear Mat the appropriate funding for start-up ventures is equity capital. Equity investors tie their fortunes to the risk of failure of the enterprise they back. They take high risk for high reward and understand that the failure of the enterprise means the probable loss of their equity. This is clearly an inappropriate role for bank lending. One of the primary functions of the banking system is to provide a safe home for depositors' savings. This means that the quality of its assets must be excellent. Banks are leveraged 20 to 1, spreads to cover loan losses are small, and, to quote one Citibanker: "Banks need to bat around .990 to survive." It is therefore standard credit doctrine in American commercial banks that loans to start- ups cannot be solely dependent on the success of a single innovation or product. Good commercial lending practice dictates two or even three sources of repayment in any lending situation. Adherence to this doctrine is an essential ingredient of the health and solidity of the banking system.

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458 JOHN S. REED and GLEN R. MORENO Banks may play an indirect role in the early stages of business start-ups, however. Peter Drucker has posed the question: "But who nurtures the true start up enterprise? And how? We really do not know, yet the money clearly is there. . . ,,2 It seems probable that at least part of the answer lies in the retail financial services industry. Personal savings through a growing variety of investment instruments, as well as home equity loans and other forms of secured personal borrowing, may be a large source of funding to Amenca's infant businesses. There is certainly no similar obscurity about the significant role of venture capital finance in developing the new enterprise. While small in absolute terms, venture capital finance clearly has played a very important role in the development of new companies, and particularly in those involved in in- novative technology. Large banks and other financial institutions play an important role in venture finance. The venture capital affiliates of banks appear to have pro- vided roughly $1.5 billion, or more than 10 percent of total resources, to the venture capital business by the end of 1983. In that year banks provided $130 million of the $1.8 billion incremental investment. Large banks are dominant in this process; fewer than 100 banks are active, and a handful provide between one-third and one-half of total bank venture capital funding. Citicorp's venture capital portfolio at the end of 1984 had 122 investments, with a market value of over $300 million. Our investments span a broad range of industries, including information technology, health care, energy, and transportation. We also maintain a $200 million leveraged budget fund to enable managers to purchase and run their companies. This is often an important further source of innovation in the companies concerned. Banks and insurance companies tend to specialize in the later stages of venture capital financings. Increasingly, these institutions provide important liquidity in the expansion of venture companies. This makes the venture capital business less dependent on the fluctuating outlook for public sector securities offerings and provides additional staying power in troubled times. Large banks have played an important role in the development of the innovative financing techniques of venture capital. They have provided many talented people for the venture capital industry and have been instrumental in establishing the industry outside the United Sates and in transfemng professional skills and knowledge. Citicorp, for example, has been an im- por~t factor in the relatively young venture capital market in the United Kingdom since 1980 and has over 20 million invested in almost 30 com- panies. We have also recently established new venture capital businesses in West Germany, France, and Italy. We are generally viewed as an important source of financial innovation in those markets. ~ Venture capital affiliates offer an interesting example of how a bank's holding companies can respond to the different needs and opportunities of

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THE RO' F: OF LARGE BANKS IN FINANCING INNOVATION 459 new ventures without compromising the lending practices of their commercial banking arms. They function with specially trained staff usin, quite different investment criteria. Thus, banks can play an active role in one of the most innovative sectors of finance while maintaining the prudential standards re- . . . . . . qulred or c ,eposltory Institutions. BANKS AND THE EMERGING GROWTH COMPANY One of our colleagues describes the very different roles of bank lending and seed capital in this way: '`The venture capitalist finances ideas the banker finances sales." Once a company has begun to translate its products and services into sales revenue, banks can begin the process of evaluating the ongoing commercial viability of the enteIpnse. That analysis is not limited to the new product itself, but to the overall capabilities of the company: management, marketing, and finance. In this sense, financial intermediaries play an important role in screening the commercial usefulness of technological innovation. The banker who extends credit, or the investment barker who takes a new company to the public markets, is perfo~ing a financial "gatekeeper" role analogous to that ascribed by Nathan Rosenberg to the technical gatekeeper in user in- dustnes. In a broader context, the aggregate of these screening decisions probably represents a valuable economic benefit. The financial gateway func- tion helps to ensure that scarce resources are allocated to those innovative opportunities most likely to bring maximum economic return. Initial banking contacts for the emerging company tend to be established win local or regional banks, due to He strong local networks and knowledge of the local marketplace that these banks enjoy, and because local banks can provide checking accounts, payroll services, and other depository and ~ans- actional services to new companies. These noncredit services are an important link to subsequent bank credit, since bankers have much better insight into the financial affairs of a young company when they are involved in its trade payments and have a reasonable overview of its flow of funds. It is worth noting Hat regulatory constraints on interstate banking prohibit all institutions from providing local depository and payment services. This, in turn, limits or delays their ability to begin providing credit at an early stage in the development of new companies. It is thus probable that regulation has limited the flow of funds from large financial institutions to smaller companies. Logic dictates that this restriction limits competitive choice and increases the cost of financing in these Finns. Large banks begin to play a significant role in the emerging company's affairs when its financing needs become large in comparison with the normal lending capabilities of local banks. This relationship generally begins with the desire of the company to establish contact with a major institution that

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460 JOHN S. REED and GLEN R. MOP`ENO will have the capacity to meet significant financing requirements in future years. As a company grows, large banks tend to satisfy its increasingly complex financial needs. The introduction of financial management systems to control and optimize cash flows offers one example. Large banks also offer a growing array of risk-management techniques: financial futures, floor- and ceiling- rate products, currency options, and many other instruments designed to cushion the company against volatile financial markets. Most of these f~- nancial innovations have been developed in major commercial and investment banks. They play an important role in transferring this financial technology to the emerging company. Most technology companies are involved in international markets at a relatively early stage. This occurs through export sales and component or assembly relationships abroad. Meeting the international financial needs of these companies is very much the province of large banks, which represent a very high percentage of U.S. overseas bank branches. The banks' knowledge of overseas markets and how to do business Here is very important to younger companies. They also provide local-currency financing for new entrants into overseas markets where capital markets are not as deep as in the United States, and it is the bank's introduction and assessment of the company that may well establish its credit standing in those markets. All of this highlights the important role that large banks play in assisting the emerging company to develop financial skills and capabilities to help it manage its growth in the United States and world markets. Through the development of increasingly complex financial problems in a competitive world, banks provide support to the growing company well beyond the simple prOVlSlOn OI nIlanCe. FINANCING INNOVATION IN THE ESTABLISHED COMPANY The most important role of large financial institutions probably lies in financing technological innovation in the large and established companies that represent such a significant portion of the total U.S. and global economy. Within the "safe confines" of these established enterprises, the evidence is that technological innovation imposes an increasingly heavy burden. Nathan Rosenberg has noted that: "A central feature of high-technology industries that is likely to become increasingly significant is an apparently inexorable rise in the development costs of new products."3 There is a popular tendency to equate invention and innovation with small companies. Indeed, the list of significant technological innovations generated by small enterprises is impressive. But it would be wrong to ignore the tremendous importance of research, development, and innovation activity Hat occurs in the world's large corporations. To our knowledge there is no

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THE RO' F OF LARGE BANKS IN FINANCING INNOVATION 461 significant relationship between innovation and the size of a firm. R&D expenditures and patent activity tend to show roughly the same proportion to sales in both small and large companies. While these are not the only proxies for technical innovation, the implication is clear that innovation is not predominantly a small-company phenomenon. Finally, of course, small companies that consistently introduce successful innovative products tend to become large companies very quickly, and some, like IBM, become giants in the global economy within a generation or so. Financing development costs Rough increasingly innovative financial techniques is probably the key challenge faced by large financial institutions in supporting technological innovation. Indeed, it is arguable that innovative financial techniques have been instrumental in clearing He way for com- mercial development of some key technological applications. Following are some important examples, starting with Be commercial aircraft industry regarding which Rosenberg has highlighted "the extreme impact of rising development costs in the commercial aircraft industry es- pecially since the advent of Be jet engine in Be l950s...."3 Banks played an important role in Be introduction of jet aircraft to the commercial airline industry beginning with the Boeing 707 and Be Douglas DC-~. In the late 1950s and early 1960s, the commercial airlines faced the need to finance aircraft costing up to $5 million as opposed to Be $1 million or less typically paid for nonjet aircraft up to that tune. The money center banks developed new forms of revolving credit and brought in long-term money from Be insurance industry to finance these purchases, thus helping to create an adequate market for the production of the 707 and the DC-~. Later, when the 727 was being considered for production, there was con- cern Mat one major carner's inability to finance new aircraft would jeopardize the entire program. Citibank, Chase Manhattan, Boeing, and Eastern Airlines executives worked out a financing program that made development of this commercially successful aircraft possible. Aircraft leasing was a financial innovation directly attributable to a small group of bankers and lawyers who introduced the investor tax lease. This financial innovation became a critical factor in financing future commercial al aft sales on a large scale. Another was the development of export finance program in conjunction with the Export-hmport Bank. The Boeing 747, the first commercial wide-bodied jet, was originally financed by a $1 billion syndicated credit led by Citibank a huge amount for a single credit in the late 1960s. Nor was that loan without its moments of drama; difficulties with the jet engines for the "jumbo" delayed sales and put the entire program at risk. The banking syndicate involved, which in- cluded all major U.S. banks in those days, was held together and provided additional finance Trough a very difficult and trying period for Be company and Be banks involved. The point to be stressed is that in several crucial phases of the development

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462 JOHN S. REED and GLEN R. MOFUENO

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THE ROLE OF LARGE BANKS IN FINANCING INNOVATION 463 LARGE FINANCIAL INSTITUTIONS AS GLOBAL INTERMEDLARES The rapid development of global, integrated capital markets may provide the long-term solution to large-scale funding needs of the new technologies. That integration is being driven by the world's leading commercial and investment banks. The grown of the international capital markets has, of course, been dra- madc over He past two decades. Total international bank lending, for ex- ample, has been estimated by the BIS at roughly $1.2 trillion at the end of 1983. This large Eurocredit market has been supplemented In recent years by market developments, which clearly suggests the emergence of a single, global, integrated capital market. Eurobond borrowing, for example, was until recently a relatively small portion of the worId's capital markets reserved for public sector borrowers and He very best known international companies. It has now become an important source of finance for many corporate bor- rowers, including U.S. companies. International bond issues by U.S. com- pan~es tripled in 1984 to U.S. $24 billion out of total Eurobond issues of over U.S. $100 billion. The introduction of note-issuance facilities over the past year suggests the beginning of an international commercial paper market. A key development is the emergence of a variety of innovative arbitrage and hedging techniques (interest rate and currency swaps, financial futures, and currency options, to name just a few). These provide growing linkages be- tween the world's major capital markets and enable technology companies to search for capital across He globe. Examples of this trend abound: Wang Laboratories has raised funds in the Swiss franc convertible bond market. Sperry has borrowed In the Swiss franc straight bond market with a novel repayment feature In dollars. United Technologies and Intel have borrowed in the Euro-yen market, swapping the proceeds back into dollars. The significance of these developments is Hat savings are moving among the world's venous capital markets, sumulating the flow of capital from where it is produced to where it can be most gainfully employed. This is particularly evident in He case of Japan, a traditional high-savings county, which is exporting savings to the United States at a rate that substandaBy offsets its heRy trade surplus win us. Indeed, He flow of foreign capital into He United States over the past few years is ready evidence of the importance of He world's capital markets to U.S. investment and He at- tractiveness of U.S. investment oppornanides to the international investor. The world's leading banks and investment banks play a crucial role in this

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464 JOHN S. REED and G.' FN R. MORENO process through the underwriting and distribution of international securities and the provision of arbitrage mechanisms between the various markets. This phenomenon is not limited to the debt markets alone. In the past 2 years, some major equity issues have crossed national boundaries. It is not surprising that they have been concentrated in the information and telecom- munications industries, where innovation and investment rates are particularly high. The Reuters, Telerate, and Telecom public equity offenngs, all very large by historical standards, show the ability of the U.S. and British markets to respond, even simultaneously, to major demands for risk capital. These transactions are probably indicative of future trends. Spain's private tele- communications company, Telefonica, has already announced plans for in- itial public equity issues in the world's major stock markets. U. S . bank holding companies play a significant role in these capital markets through their investment-banking affiliates. Traditionally strong in the Eu- rocredit and Eurosecurities market, these affiliates are increasingly active in the worlds stock markets. Unfortunately, banking regulation in the United States prevents the banks from providing in this country fund-raising services that are routinely provided abroad. These developments in the international capital markets probably provide the most striking example of the impact of financial innovation by large institutions on the funding alternatives available to companies around the world. The pace of change has been hectic, but the results are quite consistent: companies today have far wider access to a variety of sources and fonns of finance than at any time in the past. CONCLUSIONS This chapter has outlined key aspects of die role of large financial insti- tutions in supporting technological innovation. It is clear that these institutions support technological innovation in many ways: as users of technology, venture capitalists, equity underwriters, lenders, advisers and consultants, project financiers, and conduits to the international capital markets. It is equally clear that financial institutions play Heir most valuable role as innovators developing new and creative financial techniques to meet the increasingly large and complex needs of corporate enterpnses. As He demand for funds for technological innovation has increased, new financial mecha- nisms have been developed to satisfy them, and risk has been to a great extent actuarially dispersed. It is fair to conclude Hat "financial innovation does support technological innovation." A sensible goal of public policy is, therefore, to encourage the development of a responsive and innovative financial system. There is much evidence Hat policymakers around He world are moving

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THE ROLE OF LARGE BANKS IN FINANCING INNOVATION 465 toward this conclusion. In the United Kingdom, the development of a de- regulated and freely competitive financial system is seen as a critical ingre- dient in London's continuing preeminence as an international service center and in the ability of British industry to access funds in globally competitive terms. In West Germany, where the banking system has always been rela- t~vely free and competitive, there is a growing focus on the need to enhance competition and depth in the equity markets indeed, half of all new West German equity issues since the war have been introduced in the past 2 years. France has declared its support for the development of a private venture capital industry, and Italy is using, privatization of public sector industries to help stimulate a more active equities market. Even in Japan traditional market structures are changing, and the potential effects on that nation's and the world's borrowing and investment patterns are significant. All of these policy initiatives reflect a growing awareness that responsive, innovative capital markets are key ingredients to economic growth. This trend in public policy dovetails win much more fundamental forces at work in the world's financial markets. Infonnation technologies have broken Cough the traditional market barriers of geographic distance, special cartels, and exclusive market trading "floors " These technologies are bypassing cartel and regulatory segmentation of the financial markets and leading to inte- grated, competitive financial institutions. And, as we have seen, we are moving quite rapidly toward an integrated global capital market. This con- vergence of policy and market trends is encouraging, but we cannot take the pace of deregulation for granted. In He United States, the remaining panoply of financial regulation impedes innovation by maintaining artificial competitive barriers. Anachronisms like the venous prohibitions on interstate banking and the artificial division be- tween commercial and investment banking stand in stark contrast to the rapidly evolving global financial markets that this chapter descnbes. Indeed, most of these regulations predate He very existence of the technologies and industries that drive our economy today. Continuing critical review and reform of financial regulation in this county remain a key priority if we are to succeed in creating a truly innovative financial system capable of meeting the challenges of funding technological innovation in the last 15 years of this century. NOTES 1. Of rice of Technology Assessment. 1984. information Technology on Financial Services Systems. Washington, D.C.: U.S. Government Printing Office. Peter F. Drucker. 1984. Our entrepreneurial economy. Harvard Business Review 62(1): 58-64. 3. Nathan Rosenberg. 1982. Inside Ike Black Box: Technology and Economics. New Yorlc: Cam- bridge University Press.

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