A new IMF paper looks at how innovations in information and communication have (i) provided greater opportunities for new financial service entrants, such as Apple, Amazon, Revolut and N26, and (ii) challenged the traditional bank business models. The results from the paper point to two major structural changes that are occurring in the financial system:
1. Innovation in information has given rise to economies of scale in data usage, benefiting large technology firms. Bigtech firms with the informational capacity to compete have, therefore, the potential to outperform banks in financial service provisions.
2. Innovation in communication has reduced barriers to entry and weakened banks’ traditional role as the ‘first point of contact’ for financial services. This is allowing digital platforms to include financial services into their ecosystems to further reduce search and connectivity costs.
There are risks that an increased reliance on hard information and a disaggregated financial service sector will make the banking system become more volatile and less responsive to monetary policy. On the other hand, greater information and communication can increase competition and efficiency. Whichever holds most true, the paper points out that it is crucial policymakers do not fall behind the curve by protecting outdated business models, having no structured approach vis-à-vis the new entrants, and being unprepared for new technologies.
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The Context
A new IMF paper looks at how innovations in information and communication have (i) provided greater opportunities for new financial service entrants, such as Apple, Amazon, Revolut and N26, and (ii) challenged the traditional bank business models. The results from the paper point to two major structural changes that are occurring in the financial system:
- Innovation in information has given rise to economies of scale in data usage, benefiting large technology firms. Bigtech firms with the informational capacity to compete have, therefore, the potential to outperform banks in financial service provisions.
- Innovation in communication has reduced barriers to entry and weakened banks’ traditional role as the ‘first point of contact’ for financial services. This is allowing digital platforms to include financial services into their ecosystems to further reduce search and connectivity costs.
There are risks that an increased reliance on hard information and a disaggregated financial service sector will make the banking system become more volatile and less responsive to monetary policy. On the other hand, greater information and communication can increase competition and efficiency. Whichever holds most true, the paper points out that it is crucial policymakers do not fall behind the curve by protecting outdated business models, having no structured approach vis-à-vis the new entrants, and being unprepared for new technologies. An NBER paper provides yet more evidence that traditional banks are playing a less prominent role in the supply of financial services. In this case, PPP loans seems to be disproportionately provided by FinTech firms.
Frictions in Financial Systems
Let us return to the issues of moral hazard, adverse selection and ‘match-making’. Typically, there is a divide between what the business knows about their clients and what the clients knows about themselves. These frictions exist because of imperfect information and imperfect communication. Minimising them reduces risk, a valuable commodity. To resolve these frictions:
- Informational Frictions: Financial intermediaries (banks, ratings agencies, securities underwriters) have screened and monitored risky investments on behalf of the savers who cannot.
- Communication Frictions: Financial intermediaries (first-point-of-contact banks, brokers, and exchanges) have invested in the creation and maintenance of customer relationships and product distribution channels.
Superior information and communication enable financial intermediaries to exert market power. Private information generates informational capture as outside competitors face greater adverse selection. Similarly, search, switching, and transportation costs lead to communication-related ‘spatial’ capture, which allows banks to price discriminate among customers, cross-sell additional financial services and enjoy cheap and stable deposit funding.
The Times They Are A-Changing
Growing computing power and the proliferation of the internet have accelerated innovation in information and communication. This has been particularly apparent in finance (Chart 1).
Chart 1: The Finance Sector Is at the Forefront of Change
Source: Financial intermediation and technology, page 7
Innovation in Information
The first innovation, an established trend, is the conversion of soft into hard information (information that is quantitative, easy to store and transmit in impersonal ways). The second, a new development, is the emergence of vast nonfinancial data on consumer choices and preferences. The internet facilitates using new types of nonfinancial customer data such as browsing histories and online shopping behaviour of individuals, or customer ratings for online vendors.
Another new development is using ‘big data’ analytical tools such as machine learning and artificial intelligence (AI) to analyse the vast amounts of nonfinancial data collected by large technology firms through their consumer-facing platforms in the areas of e-commerce, social networking, and online search. This delivers new insights, including for financial decision-making.
Innovation in Communication
‘Communication’ refers to the establishment and maintenance of customer relationships as distribution channels for financial services. The established trend in communication innovation has been to move from in-person to distant interactions. This has enabled the entry of specialized players that focused on communication as a comparative advantage. In the market for deposits, it gave rise to direct banks that operated without a physical branch network and relied on third-party ATMs. In lending markets, independent mortgage originators offered faster credit approval relative to traditional banks. The new entrants competed with incumbent institutions on price and convenience.
More recent developments are around low-cost search, matching and distribution through digital platforms and mobile devices. Today, new entrants can set up new and efficient communication channels via web portals and mobile apps at very low cost, and reach targeted audiences via direct marketing tools, including social media. For example, so-called ‘neo banks’, such as Axos, Revolut, and N26, are challenging incumbents by offering customer-friendly interfaces and employing more efficient IT processes. Also, in payments, new entrants such as Paypal, Adyen, and Stripe, specialize in facilitating payments for online purchases, and more broadly provide interconnections between payment systems in an increasingly globalized world
The internet has also given rise to digital platforms as powerful intermediaries that consolidate information, match buyers and sellers, and enable peer-to-peer communication. Financial services fit well into these platforms, both as standalone products (e.g. savings accounts) and through synergies with other goods and services offered on the platform (e.g. consumer credit in e-commerce). Digital platforms also exhibit significant feedback effects between information and communication. Their communication advantage – their role as a first point of contact – gives them abundant data on consumers and sellers, and so also generates an informational advantage. Therefore, platforms are able to exert both informational and spatial capture.
The final novel dimension of platforms is that their overwhelming market power over distribution channels gives them an advantage over banks at enforcement. The threat to exclude customers after missing credit repayments may weigh heavily, especially in weaker institutional environments.
Table 1: New Developments Are The ‘Disrupters’
Source: Financial intermediation and technology, page 8
The Upsides and Downsides to Innovation
Pros:
- Codification of hard information enables borrowers to obtain credit in larger volumes and at better terms. Moreover, the ability to securitize and sell loans insulates borrowers from lender financial conditions and decreases the cost of credit.
- As the volume of codified information increases, its use will expand from the current realm of standardized products such as mortgages into more complex business segments such as commercial lending and financial advisory services – increasing efficiency and reducing costs.
- Such nonfinancial data are valuable for financial decision making. For example, using easy-to-collect information such as the so-called ‘digital footprint’ performs as well as traditional credit scores in assessing borrower risk.
- There are complementarities between financial and nonfinancial data: combining credit scores and digital footprint further improves loan default predictions. Accordingly, the incorporation of non-financial data can lead to significant efficiency gains in financial intermediation.
- The literature confirms the usefulness of AI and machine learning in finance. For example, the internal ratings of MercadoLibre, an online marketplace in Latin America, has been shown to predict default risk better than credit scores.
- Finally, the proliferation of the internet increases the overall availability of public information. This reduces informational capture and increases competition. For example, buy-side investors have increasingly looked towards ‘alternative data’ such as satellite images, credit card sales, mobility data.
Cons:
- Hard information can worsen borrowing conditions for customers for which hard information is more difficult or impossible to generate, such as SMEs or young and innovative firms. Moreover, at the aggregate level, a financial system that relies on hard information can be more volatile.
- Our recent podcast guest, Raghuram Rajan, stated in his 2006 paper that: ‘hard information allows for the design of hard-powered managerial contracts that can encourage financial sector risk-seeking and myopia’.
- Large technology firms collect vast amounts of nonfinancial data, potentially monopolizing hard data.
- Bigtech firms may also have privileged access to customer data, or their scale provides them with unfair advantages in collecting and processing information. Furthermore, the scale of potential entrants – particularly Bigtech firms – will enable them to accumulate political power.
- On a similar note, there is a tension between the private accumulation of data and the increased public availability of data. The net effect of innovations in the collection and processing of information crucially depends on which of these two effects dominates.
The Challenges Banks Face
Traditionally, banks have been able to leverage frictions, which act as a barrier to entry, to dominate the market. They could do this because they are vertically and horizontally integrated financial intermediaries.
- Vertically, they use their balance sheet to perform maturity transformation and directly interact with customers when raising deposits and making loans.
- Horizontally, banks provide services that do not directly rely on a balance sheet but have informational or communication synergies with deposit-taking or loan-granting.
Now, banks face two key challenges, horizontal disintegration through specialised competitors and re-intermediation through platforms.
Horizontal disintegration
This is communication-driven, rather than information-driven[1], which the authors argue induces deeper structural changes in financial service provision. On this front, banks face three pressures.
- Loss of the customer interface, and thus of their strong communication-based competitive advantage: No longer the first point-of-contact for financial services, they struggle to capture rents through the cross-selling of their own or third-party products.
- Specialized entrants can easily distribute their services through platforms: Since horizontally integrated banking services require no access to a deep balance sheet, non-banks can perform them. Novel distribution channels diminish banks’ position as gatekeepers to financial services and enable specialized providers to gain direct access to customers.
- Lack of regulation fuels competition: Offering specialized financial services often does not require a full banking license. For example, several jurisdictions now grant licenses for the provision of electronic payment services. This lowers the regulatory compliance costs of specialized entrants.
Re-intermediation through platforms
The rise of digital platforms fundamentally changes the way goods and services are distributed. Initially, the platforms emerged in nonfinancial sectors. Over time, however, the inclusion of financial services has naturally complemented most platforms’ business model. Since platforms may become middlemen between customers and financial institutions, their entry will introduce an additional layer of intermediation that can be labelled ‘re-intermediation’. On this front, banks face five pressures:
- Rent loss: When online platforms interject themselves between banks and customers, they capture most of the existing rents, and much of customer data. Banks thereby lose direct access to their customers and face the risk of vertical disintegration.
- Loss of market power: The most potent digital platforms are the ecosystems of Bigtech firms, which use a large customer base from their nonfinancial core activities to exert market power. They also have access to vast amounts of customer data to support their venture into finance.
- Rent-seeking by Bigtech: Customer data can be passed on to other financial service providers, like the recent agreements announced between Apple and Goldman Sachs as well as Google and Citigroup. Partnerships need not stay exclusive over time, as platforms seek to maximize their own rents.
- Balance sheet and ‘outside business’: The absence of an established ‘outside’ business means that they need to grow quickly in order to reach the critical mass required to become a ‘gatekeeper’ for customer access. Also, platforms can monetize their comparative advantages without maintaining a dedicated balance sheet
- Distribution and market reach: Digital platforms also enable specialized financial players to distribute their products more widely. This means that the vertical disintegration of the bank business model amplifies its horizontal disintegration. Not providing financial services directly also allows platforms avoid compliance costs, and, especially in the case of Bigtech firms, political resistance.
What Should Banks Do?
The future of banks may appear bleak. In the extreme, digital platforms and specialized competitors can induce a complete vertical and horizontal disintegration of the traditional bank business model. In this case, banks will be relegated to the role of upstream (noncustomer-facing) suppliers of maturity transformation services, while downstream (customer-facing) services will be taken over by platforms and specialized providers.
To avoid this:
- Improve communication and information processing through massive IT investment, most ambitiously by developing their own platform-based ecosystems to stay competitive. Such changes would be outside banks’ narrow realm of expertise and require changing their overall business model.
- Maintain their competitive advantage in serving corporate clients. This will be difficult with the fast-growing adoption of cloud computing. Bigtech firms that provide such services (Amazon, Microsoft, Google, and Alibaba) are establishing communication channels with a wide range of corporate clients, including very large firms and the public sector.
- Succeed in preserving the provision of financial service for their most information-intensive customers. This may lead to the revival of merchant banks – ‘trusted advisors’ that provide tailored solutions for corporate customers with complex needs. This would be consistent with the long-held view that, by increasing its relationship intensity, banking can survive competition.
- Apply regulatory pressure. While the question of which financial industry structure is optimal is difficult to answer, policy should aim to correct apparent market failures. Without any policy intervention (in a laissez-faire environment), loosely regulated entrants could crowd out banks even when the integrated bank business model may be optimal.
What Should Policymakers Do?
Innovation in information and communication, and the consequent shift in the financial industry structure from banks to specialized entrants and digital platforms create novel challenges for public policy:
Prudential Policy
Prudential regulation corrects excessive financial risk-taking. New technologies will challenge macro- and micro-prudential regulation on several dimensions.
- A financial system more reliant on hard information is more cyclical and crisis-prone. Further, the robustness of new lending technologies (such as P2P or those based on digital footprint data) is untested in downturns.
- The disintermediation of financial supply chains creates regulatory arbitrage concerns. Risks can become ‘hidden’ in complex network structures, placed in less regulated entities or more lenient jurisdictions.
- The concept of systemically important financial institutions and infrastructures widens. Platforms engaged in financial service provision are likely to become systemically important. Large providers of cloud services may need to be designated as systemically important infrastructures.
- Regulatory agencies must keep track with innovation and its outcomes. They will need to adjust more rapidly to new business processes and a less bank-centric financial industry structure. Regulators also need to respond to the use of new types of data and new data analysis tools in financial services.
Monetary Policy
The changes in the structure of the financial industry induced by technology will affect monetary policy transmission and implementation.
- Information and communication innovations render deposit and loan markets more contestable, which will likely amplify the pass-through of policy rates to lending conditions and deposit rates.
- As the importance of bank lending diminishes (e.g. because it is replaced by non-bank or P2P lending), so might the importance of bank capital and financing conditions for monetary policy transmission.
- The introduction of central bank digital currencies (CBDCs) may make monetary policy transmission more direct and remove the effective lower bound on interest rates.
- The increased use of collateral enabled by the proliferation of hard information will further weaken the importance of unsecured funding markets.
- This, and the diminishing role of banks, will make unsecured interbank interest rates a less effective operational target.
- Decreasing the number and importance of bank counterparties for central bank operations will spark further debate on allowing non-banks to access central bank reserves.
Competition policy
The ‘first point of contact’ advantages of digital platforms give rise to natural monopolies in communication and data collection. Competition policy should balance platforms’ incentives to invest with outsiders’ ability to access their communication infrastructure and data pools.
The Bottom Line
Private markets rarely converge on optimal information sharing and communication protocols without policy intervention. For this reason, public policy must help market participants coordinate on better standards. Crucially, however, policy has to be fair and there is a need for a level playing field in data standards between banks and non-banks. If this is done successfully, innovation will be in the interest of society. Policymakers must be quick, though, as external shocks – such as COVID-19 – can make the adoption of financial innovation more rapid.
References:
[1] The rise of hard information in the 1990s enabled independent mortgage originators, which used ratings-based certification to securitize and sell mortgage exposures to end-investors.
Sam van de Schootbrugge is a macro research economist taking a one year industrial break from his Ph.D. in Economics. He has 2 years of experience working in government and has an MPhil degree in Economic Research from the University of Cambridge. His research expertise are in international finance, macroeconomics and fiscal policy.
(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)