This policy lab is dedicated to aspects of financial stability that play a central role in the rapidly changing and developing...
21 April 2020
Fintech: Friend or Foe?
Our 11 March Policy Lab included a panel discussion drawing together expertise from regulators, fintech providers and private sector banks.
Our 11 March Policy Lab included a panel discussion drawing together expertise from regulators, fintech providers and private sector banks. To enable a frank conversation, the discussion was held under ‘Chatham House’ rules. We summarise the key points below:
Why do we need to ask this question?
Material financial instability has always had its roots in new types of intermediaries and products. The UK’s secondary banking crisis of the 1970s was triggered by small banks lending heavily and with inadequate collateral, largely beneath the radar of the regulators. More recently the rise of the wholesale markets allowed institutions like Northern Rock to expand by raising short term money on the wholesale markets rather than being limited by the size of their retail deposit base.
Fintechs are a new type of intermediary and with the capacity to drive change faster than ever. The advent of the cloud has super-charged the use of machine learning and with it firms’ ability and desire to capture, store and process data. New players can use this data to capture market share by responding to consumer demand in new ways. In doing so, they have the potential to affect the stability of systemically important institutions by putting their margins under pressure.
If it looks like a duck and quacks like a duck, should you always regulate it like a duck?
The success of many fintechs is based on their ability to provide consumers with the same services they once got from their bank, but cheaper, faster or better. However, there is usually a hidden trade-off. Pre-paid currency cards offer better exchange rates than a credit card, but without the same consumer protection. Peer-to-peer lenders beat the banks on interest rates, but are not part of the deposit protection scheme, despite being regulated in the UK by the Financial Conduct Authority.
There is a risk that consumers assume that if an app performs what feels like the same service for them as their bank, then their transaction will be regulated in the same way. As new types of provider proliferate, there is an argument for a much clearer system of consumer branding.
However, regulators still need to balance their protective role with allowing positive innovation. This makes it undesirable to try to make a judgement on a new type of product or provider from the outset. They need to allow new products to gain some traction in order to properly understand the economic function that they perform and the appropriate regulatory approach. In the UK the Financial Conduct Authority has created a ‘regulatory sandbox’ to allow live experiments with new products and services in a closely controlled and monitored environment.
Big Tech companies in the finance space: too big to fail?
Cloud computing has made large technology providers an essential part of the financial infrastructure. For institutions that had once built their own technology infrastructure in-house, this introduces new types of risk, especially if they are unable to switch easily to another provider. As use of cloud technology has evolved, there is a more mature appreciation of the risks, and where once they might have pushed to become an institution’s sole provider, cloud providers are increasingly likely to propose a hybrid model integrating cloud provision with an organisation’s own technology architecture, or even to be one of a number of cloud providers.
While risks associated with use of the cloud may now be managed better, large technology companies are getting involved in financial services in new ways and increasingly are interested in offering products direct to consumers. In addition to Facebook’s Libra project, Google offers a credit card for Google Store purchases via Synchrony Bank. In Asia multi-functional platforms like WeChat make it difficult to unpick financial services from other consumer interactions, and many consider that other markets will evolve this way too.
How technology companies’ financial services operations are capitalised becomes an important question. Allowing well-capitalised technology companies to use the same capital base to underwrite banking-like activities could heighten the chances of collapse in the case of a shock, as was the case when Lloyds of London insurance syndicates were allowed to use the same capital to underwrite insurance, and to invest money to produce a return.
Regulators should also be wary of the fact that consumers are likely to implicitly trust a company that has been an integral part of their lives for the past decade. They may not consider the implications of using them as a financial services provider.
Do the incumbents and the challengers have a different approach to risk?
Many fintechs are ‘data natives’ as well as digital natives - their whole proposition is often built around using and exploiting data in new ways. Regulators also now see data as a way to open up competition, through data sharing initiatives such as the Open Banking rules in the UK. This challenges the advantages banks had in lending - they were able to conduct better credit risk assessments because of their past knowledge of their customers’ business. While they still have access to the soft knowledge of a customer that they would gain from talking to a customer about their business plan in depth, the increased competition is likely to squeeze their profit margins so that they are tempted to lend unsustainably. It may also reduce the amount they feel able to invest in understanding customer behaviour properly, at the expense of providing a positive user experience.
Despite a more competitive landscape, it is still likely that risks will be more concentrated in the new fintech providers. Their focus on a smooth customer experience may mean less rigorous interrogation of a potential customer’s circumstances, and they are also likely to attract customers that have been rejected by other lenders. In the UK and China a number of peer-to-peer lenders collapsed over the course of 2018-19, a trend which may accelerate in the face of the economic shock caused by Covid-19.
Traditional providers may have an advantage when it comes to technology risk too. They will have
decades of experience of technology risks through managing their own on-premise technology architecture. New players might not have this internal skill set. They may also be more reliant on buying services from vendors without being able to properly assess the risk of doing so.
Fintech as the regulator’s friend
As well as risks, financial technology innovation can also bring substantial benefits that support regulatory and broader social goals. For example, fintech is enabling new identity management technologies, big data applications that help spot potential criminal activity, and machine-readable regulation that should make it easier for businesses to comply with their regulation.
Fintechs can also potentially support underserviced parts of the market. In the UK, when big bank lending to small to medium enterprises dried up in the wake of the financial crisis, peer to peer lending was a valuable lifeline for some small businesses. In emerging economies, some fintech companies are pioneering data-driven ways to assess a business’s creditworthiness based on how ‘connected’ a small business is with its local community.
Meanwhile in China, the online-only insurance company Zhong An analyses vast amount of consumer data – from credit reports to browser habits, to offer protection for those who – like a micro-business owner whose main asset is their laptop - fall beneath the threshold that traditional insurers would consider.