Fintech is democratizing financial services, creating new benefits for businesses and consumers, but also posing new risks, Mark Carney, governor of the Bank of England and chair of the Financial Stability Board (FSM), told the Deutsche Bundesbank G20 conference on “Digitizing finance, financial inclusion and financial literacy” in Wiesbaden, Germany.
As the risks emerge, government regulators need to maintain a strong focus on the regulatory perimeter, including a more disciplined management of operational and cyber risks, Carney noted in his presentation. By enabling technologies and managing risks, governments can help create a new financial system for a new age.
The end result will be more choice, better-targeted services and keener pricing for consumers while small and mid-sized businesses will have access to new credit.
Banks will enjoy lower transaction costs, improved capital efficiency and stronger operational resilience.
Most fundamentally, he said, people in financial services will be better connected, better informed and empowered.
The Benefits Will Be Tangible
Carney said millions are entering the digital financial system annually, promising faster economic growth. At the very least, existing markets and institutions will be more efficient.
Technological innovation has long been paired with finance, beginning with the ledger in the fifteenth century.
What’s new today is the opening of customer access such as the rise of mobile banking.
The ubiquity of the internet, the availability of high-speed computing, the emergence of mobile telephony, advances in cryptography and machine learning could join together to rapidly change finance.
Fintech can unbundle banking into core functions of sharing risk, allocating capital, settling payments and enacting maturity transformation. New entrants such as robo advisers, aggregators, innovative trading platforms, peer-to-peer lenders and payment service providers promise to bring new technologies to reinforce economies of scale.
Risks To Consider
Systemic risks evolve in such a scenario, Carney said. Changing customer loyalties can affect bank funding stability. New underwriting models can change credit quality and macroeconomic dynamics.
“The challenge for policymakers is to ensure that fintech develops in a way that maximizes the opportunities and minimizes the risks for society,” he said. “After all, the history of financial innovation is littered with examples that led to early booms, growing unintended consequences, and eventual busts.”
The Financial Stability Board is considering the key financial stability issues associated with fintech at the request of the Germany presidency. The board will deliver its finding to the G20 summit in July to support its goals for financial inclusion and balanced, sustainable growth.
Carney said he was a customer service representative for a bank in Canada. He discovered two types of customers: those who engaged and those who didn’t. He noticed that the engagers got more value from the bank since the employees were able to know more about what services they needed. The bank, in turn, got more in revenue and reliability.
“It could mean the difference between a restructured loan that could be repaid and a foreclosure that would bring liquidation,” he said.
Fintech companies are now providing cross-border payment services through digital wallets or pre-funded “e-money.” The technology firms get a portion of the revenues and, in most cases, all the customer transaction data.
Fintech Captures New Types Of Data
“In the process, they are systematically capturing the type of knowledge I used to gain from my daily interactions with customers in the bank branch,” he said.
The result is that the “historic preserve” of financial institutions is opening up to new players. Aggregators that make use of APIs are offering access to price comparisons. Robo advisers are implementing algorithms for affordable investment advice.
As customers rely more on machines, their money is being better matched with the best rates. If new technologies and public policy joined to create universal digital credentials, flows would become seamless.
In some G20 nations, new models utilize big data and analytics to match products to customers and improve credit underwriting. Peer-to-peer lending has expanded fast in recent years.
Other platforms enable companies to borrow against invoice receivables, tapping data from systems customers use to manage their payables.
E-commerce platforms in China use algorithms to analyze search and transaction data to enhance credit scoring, bolstering credit availability with low default rates.
Wholesale banking is moving from intermediated trading to more electronic order-driven trading. Technology has delivered high-frequency trading firms which are estimated to account for three quarters of equity trading and around 40% of FX.
Technology will change clearing and settlement infrastructure. Technologies such as distributed ledger could improve efficiency, accuracy and security of processes.
Issues To Consider
The new technology has raised issues such as anti-money laundering and combating terrorism financing that need to be addressed. The U.K.’s Financial Conduct Authority (FCA) has taken a pioneering role in making sure financial services uphold standards to ensure the integrity of the system.
The need for improved inclusion and competition underscore the benefits of digital identities.
Technology is providing solutions. Cryptography and biometrics can validate customer identities in reliable ways and support access to the financial system. Since 2010, India has issued more than 800 million digital identities that people can use to access financial and government services.
Issues such as privacy rights and storage and handling constraints have to be considered.
Data protection issues also have to be considered. Institutions traditionally protected customer data. In contrast, social media firms share such data. Fintech envisages the gathering of extensive data. Frameworks are therefore needed for gathering, sharing and storing data.
The FSB is identifying risks associated with new financial players.
Key Questions To Consider
Key questions include:
- Which fintech activities constitute traditional banking activities and should be regulated as such? Systemic risks associated with credit intermediation including leverage and liquidity mismatch should be consistently regulated regardless of the delivery mechanism.
- How could developments affect the soundness of existing regulated firms, and what supervisory responses for them should be enacted?
- How can developments change potential macro financial dynamics such as disruptions to important markets?
- What implications are there for the aggregate level of operational and cyber risk in the financial system?
- Which fintech activities could become systemic since they provide new critical economic functions, such as a digital wallet that becomes dominant and requires more risk oversight.
Regulators are addressing regulatory issues posed by payment service innovations. In advanced economies, fintech payment service providers are not engaging in banking activities and providers have not reached systemic scale.
In the future, it is possible that virtual currencies and fintech providers that gain direct membership to central bank payment systems can displace traditional bank payment systems. This could be positive for stability, but regulators need to monitor such changes.
The Digital Economy bill in the U.K. seeks to expand the definition of a payment system to include those that become systematically significant. They would be supervised by the bank.
Implications For Financial Stability
Changing customer relationships and payments could have more fundamental implications for financial stability.
While fintech can make banking more competitive, strengthening efficiency and customer choice, the enhanced accessibility of customer interface and payment services could end universal banking as it is now known. If the universal banks lose loyalty and have weaker client relationship, liquidity risk could increase.
The diversity of funding brought by market-based finance means peer-to-peer lending can provide some small businesses and consumers with affordable credit, which retail banks cannot do. This, however, implies that borrowers could place more reliance on this source of funding. It is not clear how stable this funding will prove.
The P2P lending sector does not yet pose material systemic risks. But it always pays to closely monitor fast-growing credit sources for slipping underwriting standards. It is not known how much P2P lending can grow without business models that evolve in ways that introduce conventional risks such as leverage and liquidity mismatch.
In wholesale markets, risk management algorithms and robo advice can lead to excess volatility or drive pro-cyclicality resulting from herding. While algorithmic traders have grown more important as a market liquidity source in many financial markets, they are more active in times of low volatility, creating an illusion of plentiful liquidity that could be withdrawn during times of market disruption.
Innovations such as distributed ledgers are being tested for use within existing wholesale payment, settlement and clearing infrastructure. They will have to meet the highest reliability, privacy and scalability standards.
Operational And Cyber Risks
Fintech also brings changes to operational and cyber risks. Regulators must recognize the single point of failure risks if banks rely on providers of cloud computing services or common hosts of online banking.
The cyber threat has increased as financial firms have come to rely more on interconnected IT systems. The fintech future envisages sharing data over more parties, with more speed and automation in executing transactions, making the challenges of protecting data and system integrity greater. The insurance industry has become preoccupied with how to underwrite such risks.
The G20 in late 2016 called on the FSM to take stock of existing cyber security regulation to develop best practices.
Fintech’s biggest prize is to combine real-time, seamless payments; distributed commerce; more sophisticated targeting of clients; and more accurate credit scoring. Supervisory approaches must be refreshed.
A Regulatory Role
Regulatory "sandboxes" can allow businesses to test new products and models in a live environment with proportionate regulatory rules.
Existing authorization processes can adapt to ensure they don’t obstruct new approaches.
The Bank of England and its fintech accelerator are creating proofs of concepts with new technologies, including researching technical and policy issues from central bank digital currencies.
For fintech’s potential to come to fruition, authorities must measure its impact on financial stability.
Featured image from BBC.