Keywords

11.1 Introduction

The Global Fintech Index 2020 envisages 60% of global GDP will be digitised by 2022. Across sectors, digitally enhanced offerings, operations, and relationships will drive growth (Findexable, 2019). At the fulcrum of this Fourth Industrial Revolution is a digitally enhanced financial services sector shaped by enabling technologies.Footnote 1 Leading the charge are financial technology (fintech) and big technology(bigtech) firms. To supporters, fintech is a game changer that will disrupt or decentralise existing market structures by unbundling traditional financial services, blur industry boundaries, revolutionise how firms create value, and deliver services in ways that will democratise financial services to yield welfare gains across global society (Frame et al., 2019; FSB, 2017; Philippon, 2020).Footnote 2 Notwithstanding, the World Economic Forum cautions against unblinkered optimism noting the “huge promise” but “potential peril” of market developments.

We offer a high-level review of fintech through the lens of the supranational agencies and multilateral institutions (the Institutions) charged with monitoring the impact of developments in market structure on the financial system and finessing the regulatory architecture.Footnote 3 Interest in fintech from a financial stability perspective is recent, becoming a priority of the Financial Stability Board (FSB) in 2016. Stability rests alongside other policy objectives pursued by various national authorities, such as, consumer and investor protection, market integrity, financial inclusion, and promoting innovation and/or competition.

In a series of ongoing reports, the Institutions assess matters pertaining to fintech. The Institutions like many academics use the FSB definition of fintech as “technology-enabled innovationin financial services that could result in new business models, applications, processes or products with an associated material effect on the provision of financial services” (FSB, 2017, p. 7). While the FSB expects fintech will facilitate significant changes in financial services, it does not envisage the core functions of intermediation fundamentally changing.Footnote 4 The benefits of technological change often take time and ambiguity exists over whether benefits will materialise fully.

The Basle Committee on Banking Supervision (BCBS, 2018) considers competition policy. New fintech entrants can increase market contestability facilitating improvements in firm-level and market-level efficiencies and realisation of welfare gains. New technologies enable fintech firms to lower transactions costs by ameliorating information asymmetries; in turn, customers receive tailored financial services at more affordable rates and faster speeds. Automation could reduce regulatory costs facilitating improvements in compliance. Policy initiatives to encourage competitionin financial markets could benefit financial stability if markets fragment in ways that reduce the systemic risk potential of large incumbents. Fintech could increase consumer welfare through financial inclusion via wider access to financial services and financial deepening.Footnote 5

Fintech is challenging the regulatory architecture to deal with complementarities and trade-offs between financial stability, competition, consumer and investor protection, and financial inclusion. Small compared to banking, fintech is fast growing (BCBS, 2018). Existing regulatory structures cover some micro-financial and macro-financial risks, but other risks are not yet covered.Footnote 6 Unresolved is whether to regulate firms or their activities (Andresen, 2016). If tech firms reside outside the regulatory perimeter yet perform core banking activities or should a tightening of regulations force activities into unregulated space, unmonitored vulnerabilities could build up. Evading regulations, intentionally or not, creates moral hazard and increases tail risks establishing a channel for financial instability (Aizenman, 2020). Consistent regulatory and legal frameworks can mitigate regulatory arbitrageand contagion, ensure resilience of economies, and capture welfare gains.

Emergent technologies have challenged banking before (Alt et al., 2018; Beck, 2020). One should assess if competition stemming from the new wave of technology-driven advances threatens banks differently from earlier technological developments. Previous experience suggests banks will fight off competitive threats and uncover ways to benefit from new developments. Banks, not all but certainly larger firms, are revising their business models and implementing new technologies to devise new value propositions or risk losing customers. This is being achieved by developing fintech services in-house or acquiring off the shelf fintech firms. Evolving market structures can expose vulnerabilities to known and new risks, which can turn systemic if left unmonitored and improperly regulated.

It is too early to draw conclusions on future market structures. We can assess how the market structure is evolving. Seemingly, the future of banks involves a series of trade-offs, such as, how banks adapt to technological innovation and changes in customer demand; how competitors interact with banks; how regulators respond to benefits, risks, and competition arising from disintermediation; and on factors relating to the technology environment, regulatory framework, and ongoing financial system and political developments. The Institutions must monitor market developments to determine if and how fintech is disrupting financial services, and whether increases in competition lead to efficiency gains or financial instability (Navaretti et al., 2017).

11.2 The Institutions

The Institutions coordinate the design and implementation of rules and regulations to improve the functioning and safety of financial markets. They pursue three primary not mutually exclusive objectives. These are financial stability; competition and efficiency; and data rights and obligations. The FSB coordinates policy on financial stability. Competition policy can vary across borders although national bodies attempt to coordinate. Presently, global agreements on data rights and obligations in financial services are conspicuous by their absence. The Institutions are actively trying to close regulatory gaps notably cross-border shortfalls that are particularly evident.

We consider the Institutions with responsibilities for the financial sector and assess how responsibilities are adapting to incorporate finech. A high level of multilateral cooperation exists alongside the absence of unambiguous lines of demarcation for fintech. Competition and data could be as important as financial regulations in shaping the extent to which technology firms permeate financial services.

The FSB promotes international financial stability.Footnote 7 It coordinates national financial authorities and international standard-setting bodies (SSBs) with intent to develop strong regulatory, supervisory, and other financial sector policies. The FSB’s priorities are to identify systemic risks in the financial sector, frame policy actions to address such risks, and oversee implementation of those responses. In July 2016, an additional priority required the FSB to monitor “potentially systemic implications of financial technology innovations, and the systemic risks arising from operational disruptions” (Carney, 2016, p. 2).Footnote 8 Hence, the FSB assesses how fintech is affecting the resilience of the financial system via an examination of risks emanating from new and incumbentfinancial institutions and activities, and the market infrastructure. The FSB uses existing risk assessment frameworks to evaluate systemic risks around financial institutions and infrastructure, as well as risks outside the regulated sector. Responsibilities for macro-financial issues are embedded in the FSB SIFI (systemically important financial institutions) framework. Micro-financial risks associated with fintech fall under the FSB’s shadow banking policy. The Basel Committee’s Core Principles can assess innovations in banking and interaction between banksand fintech firms (FSB, 2017). The tension between innovationand regulation is acknowledged in the proviso that the regulatory framework must ensure “it is able to manage any systemic risks that may arise from technological change without stifling innovation” (Carney, 2016, p. 6).Footnote 9

The Bank for International Settlements (BIS, founded 1930) is owned by sixty-three central banks. It promotes monetary and financial stability and is a forum for discussion and cooperation. Specific BIS committees issue guidelines and standards for the financial sector that are relevant to fintech: the Basel Committee on Banking Supervision (BCBS) considers prudential regulationof banks and cooperation on supervisory matters; the Committee on the Global Financial System (CGFS) focuses on improving the functioning and stability of global financial markets partly by identifying potential sources of risk; and the Committee on Payments and Market Infrastructures (CPMI) considers the safety and efficiency of payment, clearing, settlement, and other arrangements.

The IMF established an Interdepartmental Working Group on Finance and Technology and a High-Level Advisory Group on FinTech in 2016 and 2017, respectively, to study economic and regulatory implications of developments in finance and technology. The IMF assesses fintech’s effects on cross-border capital flows, how the international monetary system is evolving, and the global financial safety net. Discussions between the IMF and its members on fintech topics take place through Article IV consultations, which typically involve a Financial Sector Assessment Programme (FSAP) and Financial System Stability Assessment (FSSA). In 2018, the IMF and World Bank launched the Bali Fintech Agenda, a framework on high-level FinTech issues countries should consider in domestic policy discussions (IMF, 2018). The Bali Agenda contains twelve policy proposals on how to enable fintech, ensure financial sector resilience, address risks, and promote international cooperation. The IMF/World Bank assess fintech’s potential to widen access to financial services, deepen financial markets, and improve cross-border paymentsand remittance transfer systems; and evaluate the impact of fintech as part of an analysis of disruptive technologies and the digital economy (IMF, 2019).

Other international agencies consider fintech. The Financial Action Task Force (FATF) formulates international standards on anti-money laundering (AML) and combatting the financing of terrorism (CFT). The Organisation for Economic Cooperation and Development (OECD) Committee on Financial Markets considers fintech and the digitalisation of finance, and how they contribute to economic growth. Other SSBs, such as the International Organisation of Securities Commissions (IOSCO) and the International Association of Insurance Supervisors (IAIS) review implications of developments in fintech alongside accounting bodies. The IOSCO Objectives and Principles and the IAIS Insurance Core Principles are relevant for applications of fintech in securities markets and insurance, respectively, while the CPMI-IOSCO Principles for financial market infrastructures are relevant to fintech applications in payments, clearing and settlements (CPMI, 2020).

11.3 Banks, Market Power, and Business Models

Banks enjoy “special” status because of their role in the financial intermediation process and payments system. As licensed deposit-taking institutions, banks have “privileged” access to customer deposits markets, a source of cheap and stable funds,Footnote 10 and government safety-net arrangements (OECD, 2020). The “protection” of deposit insuranceschemes, lender of last resort function, and implicit too-big-to-fail status are sources of competitive advantage that serve to instil trust in banks and the banking system.

Banks issue financial claims and transform the size, maturity, and risk characteristics of liabilities as they cross balance sheets to become assets which provides liquidityto borrowers. Frictions inhibiting intermediation impairs the efficient allocation of capital. Banks (and other financial intermediaries) are adept at overcoming information (adverse selectionand moral hazard) and communications (match making) frictions (Boot et al., 2021). Banks eliminate frictions by collecting and processing large volumes of customer information. For instance, banks assess and manage credit risk by screening loan applicants and monitoring borrowers’ behaviour to ensure compliance with contractual terms. Engaging in repeat transactions and re-using proprietary information improves the efficiency of monitoring (and is a source of scale economies). Relationship banking and product distribution channels like branches resolve communication problems.

However, banks could use skills in information processing and communications to exploit market power. Boot et al. (2021, p. 4) note that “private information generates informational capture as outside competitors face adverse selection” while “search, switching, and transportation costs lead to communication-related ‘spatial’ capture, which allows banks to price discriminate among customers”. Frictions and licensed status are barriers to entry which dampens contestability in financial markets. Market power/rent extraction has unambiguous and negative connotations for consumer welfare.Footnote 11

Irrespective of market power issues, in banking competition policy is cognisant of a trade-off between competition and financial stability (Schaeck & Čihák, 2014). Until recently, regulators have granted banks some degree of market power on grounds that removing barriers to competition could incent greater risk-taking if the outcome was to compress net interest margins and profit (Berger et al., 2009). This charter value hypothesis attaches positive outcomes to licensing, for instance, making banks more forward-looking, and incentivising relationship building to establish the trust of customers. Thus, market power could incent lower risk-taking, which reduces bank instability and systemic risk (Boot et al., 2021).

Banking is heterogeneous. Banks are often classified by ownership and size. Such characteristics influence a bank’s activities and choice of business model. An assessment of business models could indicate which might be more susceptible to competitionfrom FinTech. It is worth emphasising that despite claims fintech will facilitate disintermediation at banks’ expense, the fintech sector is small compared to banking with the bulk of fintech services in payments, which resides outside the regulatory perimeter. Boot et al. (2021) outline two ways in which fintech could prove highly disruptive: first, if new communications channels enable fintech firms to circumvent banks’ distribution networks and offer financial services absent a balance sheet; second, if digital platforms insert themselves between banks and customers to capture rents.

Large systemically important banks and other larger firms operate as universal banks with activities spanning retail and wholesale banking, investment banking, trading, and insurance. Each activity faces potential competitionfrom fintech firms. For instance, banks’ retail lending decision-making is mostly transactional, automated, and based on credit scoring. Corporate lending decision-making, especially to large customers, uses hard and soft information gleaned from relationship banking and involves credit committees. Small and medium-sized banks are more reliant on traditional intermediation and serve smaller retail and corporate customers. Smaller firms resolve information problems by building relationships with opaque customers like SMEs possibly underserved by larger banks.

The literature on bankbusiness models attests that choice of business model affects performance outcomes and behaviour. Based on cluster analysis of balance sheet structures, researchers have identified commonly used business models: Investment, Wholesale, Diversified Retail, and Focused Retail (Ayadi & de Groen, 2016); Specialised, Diversified, Trader, and Investment (Hryckiewicz & Kozlowski, 2017); Specialised Commercial Banks, Specialised Investment Banks, Diversified or Universal Commercial Banks, and Diversified or Universal Investment Banks (Merck Martel et al., 2012). The choice of business modelimpacts bank stability (Kohler, 2015) while the structures of banks’ assets, liabilities, income, and capital affects performance (Mergaerts & Vander Vennet, 2016). Adopting a financial markets valuation approach, Venturelli et al. (2020) find market-oriented banks achieve a better risk-return trade-off, which they attribute to higher levels of trading and other activities, such as custody, administration of securities, underwriting, portfolio management, and advisory service. Examining changes in business models, Ayadi et al. (2020) find higher risk and lower profitability banks are more likely to change and in ways that foster improvements in bank stability, profitability, and cost-efficiency. One can draw inferences on the impact of fintech and how banks might respond to disintermediation and competition.

11.4 Fintech Innovations and Associated Risks

The BCBS (2018) categorises fintech innovations into three product sectors relating to core banking activities: credit, deposit, and capital-raising services; payments, clearing, and settlement services; and investment management services.Footnote 12 Market services or new technologies support product areas, for instance, cloud computing, AI, and DLT. Termed enablers, fintech impacts the financial sector by utilising innovative technologies to reduce frictions and realise stability and societal gains. Classifying fintech developments by economic function isolates financial stability implications of fintech by focusing on activities and outcomes rather than on firms and/or underlying technologies.

The FSB (2017, p. 11) predicts “material” implications for market structure resulting from changes to customer preferences, technology, and financial regulation either singularly or via interactive effects. Carney (2017) considers the impact of fintech on the financial services value chain. His hypothetical universal bank performs five core activities: customer relationships; retail and commercial banking; wholesale banking; payments services; wholesale payments, clearing, and settlement. Against each activity, Carney maps corresponding fintech services, qualifies their benefits, and identifies attendant risks associated with fintech’s development and disruptive influence on banking. Table 11.1 shows the mapping alongside a synopsis of each activity’s benefits and risks.

Table 11.1 Core banking and Fintech: competitive outcomes and risks
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How market structures evolve is a critical issue. A priori unbundling is expected to increase competition and market contestability, improve efficiency, and widen consumer choice leading to welfare gains.Footnote 13 Banking markets are commonly oligopolistic and characterised by explicit and implicit entry barriers; for instance, prudential and licensing requirements, network externalities, high fixed production costs, and values customers place on trustand reputation. While fintech’s user-friendly platforms and fast onboarding can incentivise switching behaviour, especially tech-savvy younger generations, bank customers are renowned for loyalty. It is uncertain whether, and/or to what extent, fintech will challenge banks’ market power, suggesting welfare gains might not materialise as expected.

An alternative scenario envisages market power shifting from banks to a small number of large, dominant tech firms. Fintech firms can achieve powerful network externalities due to their scalability with potential to create natural monopolies, which could instigate consolidation of financial services and increase concentration risk. This view perceives fintech firms as profit maximisers that fail to internalise the public good feature of financial stability (Aizenman, 2020). Rent extraction and associated societal costs remain.

The FSB (2017) identifies four potential benefits to financial stability from fintech. First, if decentralisation reduces entry barriers and enables smaller firms to compete more effectively, for instance, robo-advisory services and use of big data and automation in originating credit and reducing compliance costs. Diversification can lessen the probability of contagion effects from firm failures. Second, more contestable markets and application of productivity-enhancing technologies in front and back-offices realises efficiency gains. Third, greater transparency improves quality of information to enhance measurement and pricing of risks. Fourth, as a provider of “debt-based alternative finance”, fintech widens access to financial services yielding increases in financial inclusion for underserved customer groups. Alternative finance is especially important in EMDEs that have benefitted from applications like mobile banking. Greater inclusion, say, through equity crowdfunding and fintech lending, can diversify investment risk.

The Institutions classify risks to financial stability emanating from technology as micro-financial and macro-financial risks (FSB, 2017). Micro-financial risks fall into financial and operational risks and indicate vulnerabilities that might arise if fintech underestimates risks and/or shocks disrupt markets. Financial risks include credit intermediation arising from mismatches in maturity transformation, leverage, and liquidity (whether a bankor fintech provides the service). Marketplace lending poses a competitive challenge to retail banking though several uncertainties abound. First, can marketplace lending (P2P) evolve without assuming conventional risks (maturity transformation, leverage, and liquidity mismatches). Second, which quality of underwriting standards will emerge. Third, how might fintech lenders tolerate losses. Regulators must monitor the effects of increased competition. Greater fintech adoption suggests softening of customer relationships and fewer cross-selling opportunities for banks; this could destabilise bank funding and increase liquidity risk to pressurise net interest margins and profitability. Adversity often induces risk-taking to the detriment of financial stability.

Banksand fintech firms must manage operational risk including cyber risk.Footnote 14 Single point of failure risks become more likely if players rely on a small number of shared hosts, for instance, providers of online banking services or cloud computing services. Disruptions to third-party services, say, cloud computing services could undermine systemic stability if services become dominated by large firms. Cyber-risk is expected to rise as larger numbers of different firms and systems become connected. Yet, fintech-enabled competition and diversity could lessen systemic severity of a single cyber-attack.

Legal and regulatory risks can materialise from weaknesses in governance and control of processes. Risks arise because fintechfirms rather than the activity they perform lie outside the regulatory perimeter or are subject to lighter regulation. Ramifications exist for partnerships between well-regulated and weakly regulated firms. Regulatory treatments of fintech issues, such as privacy and data ownership vary across jurisdictions inferring that cross-border activities, say, in payments constitutes a challenge for regulatory frameworks. Lastly, business risks of financial market infrastructures can arise if critical financial services are adversely affected by other parts of a firm’s business.

Innovations and fintech activities could amplify macro-financial risks to undermine financial stability. Increasing interconnectedness of larger numbers of different types of firms, and sharing of data and at faster speeds, create challenges in maintaining the security of the ecosystem. Domino effects/commonalities transmit contagion risk, say, reputational contagion risk should problems at a single fintech lead to sectoral concerns. Automation and/or limited human involvement, for instance, in trading creates new sources of contagion.

Procyclicality in lending, pricing of risk premia, and deleveraging under distress exacerbate downturns. Fintech activities like marketplace lending may face bigger changes in sentiment potentially disrupting credit markets. Ambiguity resides as to how credit standards will evolve and their accuracy. Whereas marketplace lending might increase financial inclusion, wider access can create dependencies and it is unknown how stable marketplace lending will be through-the-cycle. Automated trading based on common algorithms may cause herding behaviour to disrupt diversification and amplify swings in asset prices. While electronic trading has created market liquidity, it is uncertain how markets would respond to shocks and whether liquidity would be withdrawn when most required.

Excess volatility or market overreactions can create liquidity and solvency problems that impair asset and credit markets. Commonality of business models constitutes a transmission channel. The speed at which fintech firms’ complete transactions can increase volatility. Aggregators, for instance, move cash quickly around the banking system in response to changes in prices and relative performance. This might increase the volatility of bank deposits to the detriment of bank liquidity positions.

The increase in numbers of systemically important firms deemed too-big-to-fail could amplify risks, say, by incentivising moral hazard behaviour that encourages risk-taking to exploit safety net arrangements. The emergence of dominant firms creates market power issues including anti-competitive behaviour like predatory pricing. New monopolies could emerge if a new technology comes to dominate activities essential for providing financial services, such as collection and use of customer information.

11.5 The Evolving Market Structure

The emergence and fast growth of fintech has introduced new competitors and new technologies leading to predictions that fintech will democratise financial services and create economic and welfare gains. It is too early to say how market structures will evolve. Certainly, the paucity of data on fintech hinders any assessment. Financial marketincumbents like banks hold comparative advantages in terms of lower costs of capital, large numbers of customers, and intimate knowledge of/compliancewith regulations. Many financial markets are oligopolistic and dominated by a few, large firms with plentiful resources to meet competitive challenges. Fintech firms appear hesitant to undertake banking activities suggesting wariness of crossing the regulatory perimeter and having to comply with prudential regulations. Partnerships between fintech firms and banks are one solution that seeks to utilise each partner’s comparative advantages. Larger banks, however, are developing fintech services in-house and/or acquiring off the shelf fintech firms.

11.5.1 The Impact of COVID-19

Since 2020, use of fintech services has increased sharply especially in digital paymentsand remittances (World Bank & CCAF, 2020).Footnote 15Fintech is perceived to support national regulatory objectives, particularly, financial inclusion (70% of respondents), market development (61%), adoption of digital financial services (53%), and promoting competition(47%). Fintech’s highest perceived negative impact is on consumer protection with the pandemic increasing risks in cybersecurity (78% of responses place in top three risks), operational risks (54%), and consumer protection (27%).

CCAF et al. (2020) surveyed fintech firms to assess the impact of the pandemic.Footnote 16 In H1 2020 and on average, fintech firms’ transactions numbers and volumes increased year-on-year by 13 and 11%, respectively. Fintech firms in EMDEs achieved faster growth (numbers, 15%; volumes, 12%) than counterparts in advanced economies (11, 10%). Some sectors achieved above-average growth in transactions volumes, for instance, digital asset exchanges, digital payments, digital savings, and WealthTech (over 20%). Growth was more modest in digital banking, digital identity, and regtech (around 10%). However, digital lending has struggled with contractions in transactions volumes and numbers of new loans issued (8 and 6%, respectively), and increased defaults on outstanding loans (9%).

Fintech firms responded to the pandemic by making changes to products or services typically fee or commission reductions/waivers, and changes to qualifications/onboarding criteria. The pandemic has negatively affected firms’ capital reserves, valuations, and outlook on future fundraising. Many firms perceived an increase in cybersecurity risk and introduced enhanced fraud/cybersecurity features. Increases in liquidity risk and FX exposure risk were also reported.

11.5.2 Fintech Adoption Rates and Impact on Banks

The latest Global FinTech Index of the adoption rate of fintech services shows a sharp upward trajectory: from 16% (2015) to 33% (2017) to 64% (2019) (EY, 2019). Classifying fintech services as either “disruptive” (incumbents offer the service, say FX trading), or “invented” (a new service based on technological developments, say, P2Plending and mobile phone payments),Footnote 17 EY considers fintech a “sophisticated” competitor with global reach and no longer a disruptive influence. Demarcation lines between fintech firms and incumbents are blurring as banks and other incumbents now offer fintech services, which is driving fintech adoption rates (EY, 2019). Table 11.2 provides an international perspective on fintech adoption rates.Footnote 18 Adoption is highest in EMDEs, such as China, India, and Latin America. In advanced economies, rates are highest in the Netherlands, UK, and Ireland, partially reflecting development of open banking. The adoption rate for SMEs is 25%; 56% of SMEs use a banking and payments FinTech service, and 46% a financing fintech service.

Table 11.2 Consumer fintech adoption: an international perspectivea
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Chen et al. (2020) estimate the value of fintech innovations from published fintech patent applications in the US from 2003 to 2017. Values are indicative of gains to financial services firms from developing in-house fintech services. Private companies and individuals hold a higher percentage of patents (62.7%) than technology companies outside the financial sector (57.8%). Determining patent value through examination of stock market reactions to filing disclosures, the private value of a fintech innovation is $46.7 million (at 2017 prices) far outstripping the median private value for other financial innovations ($3.1 million). Blockchainand robo-advising are the most valuable types of fintech innovations. Value effects exhibit cross-sectional variation emanating from two sources: the relative disruptiveness of the underlying technology; and whether the innovator poses a competitive entry threat to the sector. Significantly more industry value is destroyed when the underlying technology is disruptive and when it originates from fintech start-ups. From the perspective of incumbents, larger firms are more able to withstand disruptive outside innovation than smaller counterparts, but this ability is linked to firms’ R&D expenditures.

Cheng and Qu (2020) devise a FinTech Index to analyse the development of fintech at banks in China from 2008 to 2017. Although bank fintech is developing along an upward trajectory, variation exists between types of banks and across technologies; internettechnology is fastest growing and artificial intelligence lagging. Bank fintech is associated with improvements in credit risk. This reflects fintech’s beneficial effect on the efficiency of banks’ risk management and/or internal governance and internal control processes.

Hong et al. (2020) investigate the effect of fintech adoption on risk-taking using account-level data obtained from China’s Ant Group, which reveals an individual’s investment and consumption behaviour. While fintech adoption fosters household risk-taking, risk-tolerant investors benefit the most. Fintech adoption helps individuals move closer to their optimal risk-taking levels with positive implications for financial inclusion.

Phan et al. (2020) consider the impact of fintech firms on bank performance. Their evidence from Indonesia exemplifies an emerging market and a country where the number of fintech firms has grown strongly (by roughly seven per annum over 1998–2017 to around 130 fintech firms). Increasing numbers of fintech firms correlate with significantly lower net interest margins, profitability, and yields on earnings assets at banks. Negative effects are felt by smaller and, particularly larger banks, and older banks. That fintech positively affects aspects of younger bank performance suggests younger firms can be expected to successfully adopt new technologies.

11.5.3 Impact of Fintech on Core Banking Activities

Petralia et al. (2019) survey nearly 60 market participants (banks, fintech, bigtech) to determine how competition is affecting provision of banks’ primary functions (maturity transformation; payment services; information processing; risk pooling/liquidity provision). Respondents selected financial products and services: (1) most affected by technological developments now; (2) likely to be affected over the next five years; and (3) seeing the greatest competition. Across (1) to (3), payment services are most important followed by products and services under maturity transformation and forms of information processing facing digital disruption. Survey respondents claim that technology developments have enabled improvements in service quality and better understanding of customer behaviour. Over time, better data, algorithms, and AI are expected to improve regulatory and security processes and success rates for detecting and preventing fraud.

Respondents answered two open-ended questions: (1) how are technological developments most significantly impacting existing products and services? (2) thoughts on the structure of the financial services industry in five years. For (1) most bank respondents cited digital transformation as a priority to improve efficiency and products, reduce product development times, downsize branch networks, and improve risk managementparticularly compliance. However, digital transformation is constrained by regulatory and compliance costs, customer protection legislation, the low interest rate environment, and competition.

In five years, respondents expect a more diverse ecosystem with banks, fintech and bigtech firms competing and partnering at the same time. It is unclear how this ecosystem will evolve. With consolidation appearing necessary, some respondents consider small-to-medium-sized banks to be targets whereas others look at larger banks particularly in Europe and those unable to effectively evolve their business model.

11.5.4 Fintech and Credit

Cornelli et al. (2020) consider the transformation of credit markets following the emergence of alternative sources of credit. Using data on fintech credit volumes from the Cambridge Centre for Alternative Finance (CCAF), Cornelli et al. examine new flows of fintech credit across global credit markets. The analysis distinguishes fintech credit from bigtech credit: typically, fintech credit is provided via decentralised platforms which match borrowerswith lenders; for bigtechfirms, lending accounts for only a small part of mainly non-financial business.

The global market for alternative credit reached $795 billion in 2019. Although slowing down, growth averaged 15% per annum over 2017–2018 and 2018–2019. In 2019, bigtech credit accounted for around 72% and fintech roughly 28% of total alternative credit. Table 11.3 shows the top ten ranking countries in 2019. China has the largest flows of alternative credit followed by the US, Japan, and the UK. A strong emerging markets presence characterises the leading countries. Whereas credit from bigtech firms is more important in China and Japan, fintech credit holds sway in the US and UK. Table 11.3 reports growth rates over 2018–2019, and the ratio of (the flow of) total alternative credit-to-(the stock of) total domestic credit by the financial sector. This metric reaffirms alternative credit markets are small in comparison to traditional banklending. The analysis suggests alternative credit markets complement traditional credit markets.

Table 11.3 Global credit markets—alternative credit and total financial sector domestic credit
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The entry of new competitors into credit markets raises important questions for incumbent firms and their competitiveness, regulators tasked with monitoring vulnerabilities and risks, and policymakers interested in households’ borrowing and consumption patterns. For instance, which borrowers use the services of new entrants, whether new entrants attract and serve underbanked customers segments or customers with better creditworthiness, whether new entrants help customers improve their credit standing. In the US, fintech firms have targeted the large consumer credit market. Di Maggio and Yao (2020) use individual-level data to examine the market for personal credit for fintech and traditional lenders. Proponents believe fintech can reach customer segments that banks find unprofitable, which could reduce credit rationing and information asymmetries.

FinTech lenders enter the personal credit market by targeting less creditworthy individuals. Increases in market share precipitate advances in credit to more creditworthy borrowers. On average, personal credit from fintech firms is around 3% more expensive than traditional lenders. However, the difference in loan rates between the two types of lender is lower in areas where the market share of fintech is lower. This implies fintech lenders use an aggressive pricing strategy to attract new customers.

Observed variation in loan rates reflects information in customer credit reports for fintech lenders. This suggests fintech firms base their credit decisions on hard data indicating a soft information deficiency.Footnote 19 Notwithstanding, loans granted by fintech firms have significantly higher default probability than loans originated by traditional lenders by an estimated, economically meaningful 1.1%. Fintech lendersface adverse selection. Over-reliance on hard data leads to credit being supplied to borrowers rejected by banks. Fintechlenders account for this in their pricing which better predicts default probabilities (by 20%). With borrowers increasingly likely to use fintech lenders, positively affecting the lifetime value of loans, higher defaults do not produce worse outcomes for fintech lenders (Di Maggio & Yao, 2020).

Using loan-level data from a fintech in India, Ghosh et al. (2021) uncover a theoretical synergy between the growth of both fintech lending and cashless payments. Wider use of cashless payments produces borrower information outside of lenders; that borrowersexpect lenders to screen based on verifiable information boosts usage of cashless payments. Since cashless payments vary in verifiability, the fintech lender uses this information to reduce adverse selection and be more efficient in screening high from low-quality applicants. Greater use of cashless paymentsimproves borrowers’ chances of obtaining loans, and at lower rates than previously paid to traditional lenders. For loans at comparable interest rates, borrowers that use cash have higher probability to default.

Yang (2021) considers the importance of trustin banks as an implicit barrier to entry to fintech in credit markets. Using the Wells Fargo scandal as an exogenous shock to trust in banks, an increase in exposure to the scandal is associated with an increase in the probability of borrowers using fintech firms as mortgage originators. The shock affects all banks irrespective of the fact the scandal occurred at Wells Fargo. Yang examines the role of trust in fintech adoption for minority borrowers. Whereas minority borrowers do not have a smaller loss of trust, they have a smaller increase in the adoption of fintech, which suggests minorities perceive trust as less critical in fintech adoption. The increase in fintech adoption resulting from loss of trust in banking does not affect fintech firms’ loan pricing, which is consistent with fintech firms’ use of hard data to price credit. Promotion of fintech adoption is unlikely to lead to higher loan rates at fintech firms.

11.5.5 Linkages Between Fintech and Banks and the Financial Ecosystem

One option for incumbents is to acquire an off the shelf fintech firm. Pancotto et al. (2021) consider bank acquisitions of fintech firms and investigate which factors influence decisions to acquire. Acquisitions are more likely by better capitalised banks and more liquid banks, banks led by longer tenured CEOs, and banks with higher proportions of females on boards. Banks led by younger CEOs and banks with lower IT expenditures are also more likely to acquire fintech firms. In contrast, banks with higher IT expenditures are less likely to acquire, which suggests these banks favour in-house development of fintech services.

Two features could motivate partnership agreements. First, customers adopt banking services from non-traditional suppliers because of low-cost offerings, ease of use, faster service, better features, and personalised products. Second, despite banks increasing IT expenditures, customers appear largely dissatisfied.Footnote 20 Despite the rationale for fintech–bank partnerships, specific factors appear to inhibit success. For instance, the existence of cultural gaps and difficulties in communication between partners; and poor choices of partner which can cause project failure (Capgemini, 2020). Despite banks’ investing in front offices, their middle and back-office functions impact customer perceptions and are burdened by legacy IT, which hinders banks from creating “superstar” products and developing “long tails”.

Prospects for bilateral partnership agreements appear to be waning due to the emergence of fintech ecosystems involving incumbents, fintech firms, and other non-financial sector firms. The emergence of new technologies and increasing digitisation are factors with potential to shift the financial ecosystem, for a long time characterised by banks’ acting as trusted advisors to a loyal customer base. Arslanian and Fischer (2019) identify two interrelated developments: platformisation and open banking. In a platform-based marketplace model, the platform’s owner facilitates exchanges between decentralised customers and producers. Open banking requires banks to share customers’ financial data with third parties (subject to consent), which should establish a marketplace for financial services and facilitate more competitionand innovation in the sector. That open banking regulations will end banks’ monopoly on ownership of customer data has market power/welfare implications alongside shocks to bank revenues and business models.

It is worthwhile to consider which, if any, firms could come to dominate open banking. Banks, particularly the largest, are in pole position due to their “ownership” of customer data, financial sector acumen, and capital to respond to market developments. Bigtech firms are banks’ main other competitors and offer IT capabilities in place of financial know-how. Bigtech firms are expanding into financial services and reports suggest customers’ trust in bigtech matches that in banks. Full commitment to open banking requires substantial investment, which heightens probability that banks and bigtechs will partner up, and, increasingly that fintech firms will move into any unoccupied spaces.

We can glean possible outcomes associated with open banking using a theoretical model that considers competition between a bank and a fintech in the credit market when borrowers can share information (He et al., 2020). Absent open banking, the traditional bank holds an information advantage or better screening ability than the fintech (even if the fintech uses advanced data analysis algorithms). Open banking induces competition. Data-sharing enables the fintech to utilise its analytical algorithms to improve credit screening and to even surpass the bank’s screening abilities. The model supports the proposition that open banking favours the fintech. Since data sharing is voluntary, in a perverse outcome all borrowers are worse off with lower welfare even though the financial sector is more profitable.

11.5.6 Fintech and Financial Inclusion

Despite technological advances, the unit cost of financial intermediation remained near to 200 basis points for around 130 years (Philippon, 2015). Recent estimates show a decline in unit costs following the GFC (Philippon, 2020). If fintech improves the efficiency of financial intermediation, consideration should be given to how the gains will be shared, and whether fintech will democratise financial services or widen inequalities.

Philippon’s (2020) theoretical framework shows FinTech could reduce the cost of financial intermediation but regulatory changes are needed for fintech to realise its potential. In the case of robo-advisory services, technological advances are changing the nature of fixed and variable costs in ways that will widen access for less wealthy customers but may not reduce inequality across all customer groups. Similarly, fintech lending could reduce discrimination (statistical biases) in credit markets but also reduce the effectiveness of existing regulations to protect minorities.

Sahay et al. (2020) measure the contribution of digital finance (payments) to increasing financial inclusion. They construct a digital financial inclusion index and a traditional financial inclusion index (for financial intermediaries) for a sample of 52 EMDEs covering 2014–2017 (digital) and 2011–2017 (traditional). Pre pandemic, digital finance made a positive, significant contribution to financial inclusion (financial intermediation’s contribution remained constant). That digital financial inclusion is positively correlated with future GDP growth suggests fintech could contribute to growth and lower income inequality.

Jagtiani and Lemieux (2018) examine fintech lending for unsecured consumer credit against comparable lending by traditional banks to determine whether fintech can penetrate markets underserved by banks. Using loan level data from LendingClub and credit card loans data from banks’ Y-14M reports, fintech lending penetrates underserved areas characterised by highly concentrated or less competitive banking markets, greater preponderance of lower income borrowers, and low branch density. Further expansion of fintech services could fill credit gaps by supplementing existing consumer credit which can boost financial inclusion.

11.5.7 Scenario Analysis

The BCBS (2018) considers five forward-looking scenarios and associated risks (see Table 11.4). The scenarios are not mutually exclusive. The first is “Better Bank”, which envisages banks responding to competition by invigorating their business models with enabling technology to provide customers with new value propositions. Execution risk and outsourcing are potential concerns alongside increased cyber risk. The four other scenarios range from “New bank” in which banks face strong competition from new technology banks, such as challenger banks and neobanks, to “Disintermediate bank” which premises the end of banking and balance sheet intermediation with all customers’ financing requirements provided by platforms and technologies. From a financial stability perspective, the inherent risks include incentives for banks to take excessive risks as revenue streams and profits are competed away; supervisory challenges from monitoring third party relations; consumer protection, data privacyand security; greater interconnectedness and increased concentration risk arising from service providers; the possibility that bigtech firms and other fintech firms that reside outside the regulatory perimeter become dominant and abuse market power.

Table 11.4 Forward-looking scenarios: features and risks
Full size table

While it is too early to say which, if any, of these forward-looking scenarios is emerging let alone which, if any, will come to dominate, available evidence shows incumbents digitising and modernising (Better bank), and of the New bank scenario in countries, such as the UK and US, the Netherlands, Germany, and China. Features of the Distributed bank scenario are observed in joint ventures and third-party agreements between banks and fintech firms. Examples abound of the Relegated bank, which provides services to a tech firm that owns the customer relationship; for instance, bigtech firms using their social media platforms to collect and leverage customer data to offer customers tailored financial services from other providers including banks. Though the Disintermediate bank scenario may seem far-fetched, examples exist including P2P lending platforms implementing credit scoring and approval processes that are trusted by customers, and cryptocurrencies being used for paymentsand value transfers using DLT technologies and absent incumbent banks.

11.6 Concluding Remarks

This chapter has reviewed the light and dark sides of fintech through the lens of the Institutions. Fintech is fast growing and offers opportunities to enhance quality of financial services, improve customer satisfaction, increase financial inclusion, support economic growth, and welfare gains. Yet, potential exists for known and new risks to emerge and threaten financial stability, growth, and welfare. Notwithstanding, fintech firms are yet to reach the scale whereby they constitute a systemic risk (FSB, 2017). Nevertheless, financial markets are inherently oligopolistic with market power issues that competition policy is yet to resolve. Noting the possibility of a fintech or bigtech firm gaining market power and extracting rents, the Institutions must resolve if activities should fall within the regulatory perimeter even if the firm does not. The implication is for regulators to address vulnerabilities as they come to fruition by adapting existing regulatory frameworks.

The appetite of fintech firms to provide core banking services appears diminished by the prospect of crossing regulatory boundaries. Together with banks’ revising their business models to capture opportunities afforded by new technologies, cooperation might prove more fruitful than full-blown competition. Recent evidence is supportive: banks are developing in-house fintech services and/or acquiring off the shelf fintech firms; partnership agreements are plentiful (irrespective of success); fintech is boosting financial inclusion by helping to complete markets for underserved customers. In sum, available evidence implies fintech is complementing rather than disrupting traditional finance (for the time being at least).