The old and the new of fintech
Technological change in the financial industry is accelerating. Incumbents face disruption from innovative start-ups and large technology firms (Philippon 2020). The ongoing COVID-19 crisis, which has increased demand for digital services, will if anything speed-up this process. This raises some important issues. What are the key dimensions of innovation in the provision of financial services? Are they genuinely new developments, or rather the continuation of past trends?
In a recent paper (Boot et al. 2020), we develop a simple conceptual framework that distinguishes between two key dimensions of financial innovation: information (data collection and processing) and communication (relationships and distribution). Superior information and communication are key ingredients of the financial intermediation process because they allow intermediaries to overcome frictions related to adverse selection and ‘match-making’, which helps to ensure an efficient transformation of savings into investment. Moreover, they enable banks to generate market power, and the resulting ‘charter value’ makes the financial system more stable and forward-looking. When discussing the implications of innovations in information and communication for financial intermediation, we distinguish between the continuation of established trends and genuinely new developments. Table 1 provides an overview.
Table 1 Technological progress and financial intermediation
Technological progress in finance is nothing new. In particular, the proliferation of hard information and the shift away from in-person interactions are prime examples of technological progress in information and communication that predate the current wave of digitalisation. The existing literature offers useful insights on the effects of these trends:
- Hard information mostly improves credit conditions (Jappelli and Pagano 1993, Berger and Frame 2007, Loutskina and Strahan 2009). However, such information may be difficult to generate for SMEs or innovative firms, leading to worse credit terms for some borrowers (Petersen and Rajan 1994, Dell’Ariccia et al. 2017). At the aggregate level, an increasing reliance on hard information can increase the cyclicality of credit supply (Allen and Gale 1997, Bolton et al. 2016, Boot and Ratnovski 2016).
- A shift from in-person to remote communication (e.g. online banking) creates convenience for customers. With more efficient communication, the reach of financial intermediaries widens, which creates competitive pressure and increases incentives for consolidation as response to rising overcapacity in physical branch networks. Moreover, it also fosters an increase in institutional complexity as banks boost their product range to remain the ‘first point of contact’ for financial services customers (Houston et al. 2001).
These past trends stand in sharp contrast to novel developments:
- Key innovations in information are the rise of machine learning and artificial intelligence, enabled by an abundance of data. Notably, this includes non-financial data such as the ‘digital footprint’ or customer information gathered by digital platforms, which is valuable for financial decision making (Berg et al. 2019, Frost et al. 2019).
- One the communication side, the ability to establish efficient distribution channels at low cost through online portals and social media marketing campaigns has lowered barriers to entry. This enables the rise of specialised standalone financial intermediaries. Moreover, the internet has given rise to digital platforms that have penetrated much of consumers’ everyday lives. Financial services fit well into such ecosystems because they complement the consumption of non-financial goods and services. Accordingly, digital platforms have a natural interest to include financial services into their offerings. Their communication advantage may enable them to take over the role of ‘first point of contact’ with customers from banks.
The figures below illustrate the effects of technological progress in information and communication for the financial industry. Financial intermediation relies most heavily on the use of computers among all industry sectors in the economy, and the trend towards automation has led to a consistent decline in employment (Figure 1). At the same time, the share of customers who use online banking has increased from under 20% to over 50% over the past two decades, whereas the number of bank branches has almost halved over the same time (Figure 2).
Figure 1 Computer use and employment in financial intermediation
a) Computer use across sectors (EU15)
b) Bank employees per million inhabitants (EU15)
Note: The top panel shows the share of employees that report using computer at work, acrross NACE-1 sectors. The blue line shows the share for Financial Intermediation, while the shaded grey area indicates the range for other sectors. The bottom panel shows the number of bank employees per million inhabitants.
Source: European Working Conditions Survey (top) and ECB Statistical Data Warehouse (bottom). Source:. All data cover EU15 countries
Figure 2 Use of online banking and the number of bank branches in Europe
a) Use of online banking services (EU15)
b) Bank branches per million inhabitants (EU15)
Notes: The left panel shows the share of survey responents that report regular use of online banking services. The blue line indicates the average, while the shaded grey area shows the cross-country range The right panel graphs the number of bank branches per million inhabitants.
Source: Eurostat (top) and ECB Statistical Data Warehouse (bottom). All data cover EU 15 countries.
Another novelty is the change in the relative importance of information and communication in driving competitive advantages in financial services provision. The literature has historically focused on informational frictions in financial intermediation, viewing the effects of communication as mechanical and similar to those in non-financial industries. However, it is the recent communication innovation that gives digital platforms unrivalled market power. Similarly, the competitive challenge from specialised providers is largely driven by innovations in communication rather than information.
Disintegration of bank business models
Going forward, recent innovations in information and communication technologies may lead to the vertical and horizontal disintegration of the traditional bank business model. At present, there are some limiting factors to this extreme outcome, but these may decline over time:
- Specialised providers compete on convenience, efficiency, and speed. Since new communication channels enable them to side-step banks’ distribution networks, they can attempt to chip away horizontally integrated banking services (e.g. payments, asset management, etc.) that do not require access to a deep balance sheet (which they do not have). They may, however, be constrained by their narrow business models.
- Digital platforms can interject themselves between banks and their customers, introducing another layer of intermediation that captures most rents and data. So far, the reach of digital platforms is constrained by their focus on retail consumers. This may change with the rise of cloud computing, which allows large technology firms to create business-to-business (B2B) ecosystems that include large corporate customers and is able to generate information and communication advantages that can be used for the provision of financial services to these clients as well.
In the extreme, competitive forces created by technological progress can relegate banks to upstream (i.e. non customer-facing) providers of maturity transformation services. They can attempt to stave off the competitive pressures from platforms and specialised entrants by investing in the digitalisation of their own business processes. However, besides the associated costs, such transformation is often impeded by entrenched organisational cultures, reputational risks, and regulatory factors.
Technological innovations in information and communication give rise to new policy priorities:
- Prudential regulation needs to address a financial system that is more cyclical and crisis-prone due to its reliance on hard information. In addition, the robustness of new lending technologies (such as peer-to-peer (P2P) or those based on digital footprint data) is untested in downturns. Operational risks from new business models and cybersecurity issues are hard to assess. Increased complexity of financial supply chains increases regulatory arbitrage concerns, as risks become ‘hidden’ in complex network structures, less regulated entities, or more lenient jurisdictions. Digital platforms and large providers of cloud services may need to be designated as systemically important infrastructures. Critically, regulatory agencies need to ensure that their expertise matches that of the industry (Hakenes and Schnabel 2014) – something that has historically been hard to achieve and may become even harder as innovation accelerates and more talent enters the financial technology sphere.
- The transmission of monetary policy will change. Technological innovations render deposit and loan markets more contestable, which is likely to amplify the pass-through of policy rates (e.g. Drechsler et al. 2017). A better pass-through might be welcome, as a more cyclical financial system may require more countercyclical monetary policy. The introduction of central bank digital currencies (CBDCs) – also in response to payment innovations – can remove the effective lower bound on interest rates (Griffoli et al. 2018). In monetary policy implementation, the increased use of collateral (rather than soft information) in lending will further weaken the relevance of the unsecured lending rates as operational targets (English 2002). Finally, the decreasing number and importance of banks will spark further debate on allowing non-banks to access central bank operations.
- Additional priorities include those in data and competition policy (see also Carrière-Swallow and Haksar 2019, and Vives 2019).
The question of whether other entities can efficiently fulfil the economic role of banks remains open. However, even if this were the case, the transition would be complex and require fundamental policy adjustments because banks are currently at the core of the financial system.
Authors’ Note: The views are our own and not those of the ECB or the Eurosystem.
Allen, F and D Gale (1997), “Financial markets, intermediaries, and intertemporal smoothing“, Journal of Political Economy 105(3): 523-546.
Berg, T, V Burg, A Gombović and M Puri (2019), “On the rise of fintechs: credit scoring using digital footprints”, Review of Financial Studies, forthcoming.
Berger, A N and W S Frame (2007), “Small business credit scoring and credit availability”, Journal of small business management 45(1): 5-22.
Bolton, P, X Freixas, L Gambacorta and P E Mistrulli (2016), “Relationship and transaction lending in a crisis”, Review of Financial Studies 29(10): 2643-2676.
Boot, A, P Hoffmann, L Laeven and L Ratnovski (2020), “Financial Intermediation and Technology: What’s Old, What’s New?”, CEPR Discussion Paper 15004 and ECB Discussion Paper 2438.
Boot, A W and L Ratnovski (2016), “Banking and trading”, Review of Finance 20(6): 2219-2246.
Carrière-Swallow, M Y and M V Haksar (2019), “The Economics and Implications of Data: An Integrated Perspective”, International Monetary Fund WP/19/16.
Dell’Ariccia, M G, D Kadyrzhanova, M C Minoiu and M L Ratnovski (2017), “Bank lending in the knowledge economy”, IMF Working Paper WP/17/234.
Drechsler, I, A Savov and P Schnabl (2017), “The deposits channel of monetary policy”, Quarterly Journal of Economics 132(4): 1819-1876.
English, W B (2002), “Financial consolidation and monetary policy”, FRBNY Economic Policy Review 8(1).
Frost, J, L Gambacorta, Y Huang, H S Shin and P Zbinden (2019), “BigTech and the changing structure of financial intermediation”, BIS Working Paper 779.
Griffoli, M T M, M M S M Peria, M I Agur, M A Ari, M J Kiff, M A Popescu and M C Rochon (2018), “Casting light on central bank digital currencies”, IMF Staff Discussion Note, No SDN/18/08.
Hakenes, H and I Schnabel (2014), “Regulatory capture by sophistication”, Mimeo, University of Bonn.
Houston, J F, C M James and M D Ryngaert (2001), “Where do merger gains come from? Bank mergers from the perspective of insiders and outsiders”, Journal of Financial Economics 60(2-3): 285-331.
Jappelli, T and M Pagano (1993), “Information sharing in credit markets”, The Journal of Finance 48(5): 1693-1718.
Loutskina, E and P E Strahan (2009), “Securitization and the declining impact of bank finance on loan supply: Evidence from mortgage originations”, Journal of Finance 64(2): 861-889.
Petersen, M A and R G Rajan (1994), “The benefits of lending relationships: Evidence from small business data”, Journal of Finance 49(1): 3-37.
Philippon, T (2020), “On fintech and financial inclusion”, BIS Working Papers 841.
Vives, X (2019), “Digital disruption in banking”, The Annual Review of Financial Economics 11(1): 243-272.