Research & Policy Briefs From the World Bank Chile Center and Malaysia Hub No. 14, April 2018 The Fintech Revolution: A Threat to Global Banking? Juan J. Cortina Sergio L. Schmukler The period since the global financial crisis of 2008 has been characterized by the emergence of a broad set of tech-driven finan- cial companies (“fintech” companies), acting in parallel with traditional banking services. Although the new players are ramping up competition, pushing digital transformation and exerting pressure on the global financial sector, their services appear to be highly complementary to the ones provided by the more established banks, which are also embracing these technologies. The retrenchment and intensified regulation of the traditional Understanding the fintech development is important banking system after the global financial crisis, combined with because while it can increase competition and efficiency in greater access to information technology and wider use of the financial system, it also poses new types of risks. This brief mobile devices, have allowed a new generation of firms to provides an overview of some of the latest fintech develop- deliver financial services. The term “fintech” refers to this ments as well as their potential effects on global banks and new financial industry that relies on innovative technologies the financial system in general. and business models to provide financial services outside the traditional financial sector. Lending, payments, and cross- Alternative Lending border transfers are some of the segments most highly affected by this development. Other traditional financial New online platforms are offering alternative models of credit segments, such as wealth management, have also experi- intermediation. Usually referred as marketplace or peer-to- enced high penetration of fintech entrants. peer (P2P) lenders, these platforms are providing increasing amounts of credit to consumers and small and medium enter- Although the data on fintech are very scant, according to prises (SMEs). Whereas some firms participate in the lending some estimates at least 4,000 fintech firms were active in activity using their capital base (such as Kabbage), most firms 2015, and more than a dozen of them were valued at over $1 simply connect lenders and borrowers and do not bear the billion (The Economist 2015). Meanwhile, this trend is grow- risk of default (such as Lending Club). However, the term ing very quickly. The global investment in fintech was about “peer-to-peer” is misleading because most of the loans $22.3 billion in 2015—more than 12 times the investment include funding from a wide range of investors (including amount in 2010 (Accenture 2016). Although the United States financial institutions). These lending platforms have no retail and the United Kingdom appear to be the world leaders in branches and typically provide faster loan applications and fintech investments, in terms of growth, fintech has expanded smaller shorter-term loans than banks. They also replace most rapidly in Asian countries (especially China and India) in traditional credit scoring models with machine learning and recent years. Investment in Asian fintech companies algorithms based on big data mining to assess credit risk, accounted for 19 percent of the world’s total fintech invest- accelerate processes, and lower costs. Global outstanding ment in 2015, up from 6 percent in 2010. loans by marketplace platforms were estimated to be about Figure 1. Global Volumes of Marketplace Lending and E-commerce a. Marketplace Lending b. E-commerce Sales 800 183 200 5,000 18 15.5 700 180 4,500 14.6 16 153 160 4,000 13.1 14 600 140 3,500 11.6 123 12 US$ billion US$ billion 500 10.1 Percent 3,000 Million 120 94 8.7 10 400 100 2,500 7.4 8 300 68 80 2,000 6 46 60 1,500 200 4 29 40 1,000 100 20 500 2 - - 0 0 2015 2016 2017a 2018a 2019a 2020a 2021a 2015 2016 2017a 2018a 2019a 2020a 2021a Transaction value (left axis) Retail e-commerce sales (left axis) Users (right axis) E-commerce share of total global retail sales (right axis) Source: eMarketer and Statistica, May 2017. a. Forecast. Affiliation: Development Research Group, the World Bank: E-mail addresses: jcortinalorente@worldbank.org, sschmukler@worldbank.org. Acknowledgement: We are grateful to José De Luna Martínez, Adrian Gonzalez, and Norman Loayza for their useful comments and Nancy Morrison for her careful edits. This work was supported by the World Bank Knowledge for Change Program (KCP) and Strategic Research Program (SRP). This brief summarizes and expands on the material presented in Chapter 3 of the World Bank’s 2017/2018 Global Financial Development Report: Bankers without Borders. Objective and disclaimer: Research & Policy Briefs synthesize existing research and data to shed light on a useful and interesting question for policy debate. Research & Policy Briefs carry the names of the authors and should be cited accordingly. The findings, interpretations, and conclusions are entirely those of the authors. They do not necessarily represent the views of the World Bank Group, its Executive Directors, or the governments they represent. Global Knowledge & Research Hub in Malaysia The Fintech Revolution: A Threat to Global Banking? $209 billion in 2017, with 68 million active accounts (figure 1). M-Pesa make possible peer-to-peer transactions with mobile China, the United States, and the United Kingdom have the devices, without the need for a bank account. And new largest marketplace lending volumes (World Economic Forum business models such as Azimo and TransferWise allow 2015). customers to send money across borders by matching trans- actions with other users trying to send flows in the opposite Another form of online credit is offered by e-commerce direction, thereby avoiding the high fees associated with platforms such as Amazon, eBay, and Alibaba, which recently international transfers. But the most potentially disruptive started to offer loans to SMEs selling goods on their platforms. solutions in the payments and transfers arena are those based The access to the transaction history of their users puts these on the new blockchain technology. platforms in a better position (relative to banks) to assess the risk of the loans. This type of alternative lending holds great Blockchain—the technology behind the most well-known growth potential. Retail sales by these platforms have steadily cryptocurrency, bitcoin (Nakamoto 2008)—is a decentralized increased, reaching $2.3 trillion in 2017, or 10 percent of total payment scheme that does not require a single trusted third retail sales worldwide, a share that is projected to keep party to validate transactions. Because the transactions are increasing (figure 1). validated and logged by a network of computers, this technol- Technology firms are also tapping into supply-chain ogy upends one of the most important tasks of the traditional finance, pushing for the integration of financial services financial industry, which is to act as a trusted intermediary for directly into SME value chains. Although hard to measure, transactions between separated (sometimes unknown) supply-chain credit intermediated by new fintech providers entities (figure 2). In the same way the internet has revolu- seems to be growing very rapidly, given that supply chains are tionized the diffusion of information, blockchain technology extensive and demand for this type of capital has become can revolutionize the way in which parties send value. By significant (The Economist 2017). providing a faster and more efficient payment infrastructure and log of transactions, this technology can be used for many Payments and Transfers financial (and nonfinancial) processes. Innovations in payments and transfers are changing the way Several global banks and financial institutions are already consumers engage in financial transactions. The current collaborating with technology companies to further experi- system of value transfer is built on several intermediaries, ment with blockchain. For example, Ripple and R3 are trying such as automated clearinghouses and intermediary banks to create their own blockchain network for global banks, (corresponding banks), which sometimes make the process avoiding clearinghouses and correspondent banks. The US costly and slow. Innovations in this area make transactions Nasdaq stock exchange was the first to incorporate blockchain between individuals (and sometimes across economies) services. The Tokyo Stock Exchange, in collaboration with easier, faster, and cheaper than in the past. In the area of IBM, is also testing systems to record trades for payments, most of the recent innovations aim to improve the low-transaction markets using blockchain (Adriano and user experience, leveraging on mobile devices and connectiv- Monroe 2016). Other applications of blockchain include ity, although the existing payment infrastructure remains the blockchain-based property registries and smart contracts, same (such as Android Pay, Apple Pay, Square, and Stripe). In which are self-executing contracts without the third-party the transfers area, innovative mobile money solutions such as interference of lawyers or courts. Figure 2. How Blockchains Work 1 Party A contacts party B and requests a digital transaction 2 The transaction is broadcast to the network of “miners” 3 The transaction, along with others, is packaged and recorded as a block 4 The network of miners validates the block of transactions 5 The new block of confirmed transactions is added to the existing blockchain 6 The transaction from A to B is verified and completed Source: Authors’ design. 2 Research & Policy Brief No.14 Figure 3. The Decreasing Costs of and Declining Role of Banks in Sending Remittances a. Average Cost of Sending Remittances b. Banks’ Share of Remittances 14 35 13 30 Cost (% of amount sent) 12 11 25 10 Percent 20 9 8 15 7 10 6 5 5 4 0 2011 2012 2013 2014 2015 2016 2011 2012 2013 2014 2015 2016 Banks Traditional MTOs Newer MTOs Global average Source: World Bank, “Remittance Prices Worldwide,” http://remittanceprices.worldbank.org. Note: Panel a shows the average total cost (as a percentage of the remittance) of sending $200 internationally. Panel b shows the banks’ market share of the remittances market. MTO = money transfer operator. Fintech Benefits Risks and Regulation Digital innovators are bringing increased competition and Despite the potential benefits, fintech services also pose new efficiency to the traditional financial sector (Philippon 2015, types of risks. The lack of safety nets in the business models, 2016). For example, following the increasing use of fintech misuse of personal data, difficulties in identifying customers, providers, the cost of sending remittances has been declining and electronic fraud are among the main vulnerabilities of the (figure 3), while the speed of transactions has been increas- new digital financial practices. Because most of the P2P ing. This holds special importance for developing countries lending platforms do not hold the loans originated in their because remittances constitute one of the biggest flows of balance sheets, the profitability of their businesses is highly funds from the developed to the developing world. The global dependent on the number of loans they intermediate and flow of remittances was estimated to exceed $601 billion in might evaporate during economic recessions. Banks covered 2015, and developing countries received an estimated $441 by deposit insurance schemes are better equipped to cope billion of that total (World Bank 2016). with economic downturns (Demirgüç-Kunt, Kane, and Laeven 2014). As for payments, the anonymity, speed, and global Importantly, the development of fintech also promotes reach of some crypto-currencies (namely, bitcoin) can financial inclusion for consumers and SMEs. Historically, there facilitate tax evasion, money laundering, and the funding of has been a wide gap between the financial needs of house- illegal activities. For example, the “Silkroad” was an anony- holds and businesses in developing countries and the set of mous e-commerce platform that allowed for any type of financial products available to them. The banking sector has product (including illegal ones) to be traded through the use constrained lending to this segment, among other reasons, of Tor (an anonymous browser) and bitcoin (an anonymous because of the high costs relative to the small transaction form of payment). Another potential problem of the use of values involved and the difficulties lenders have in identifying cryptocurrencies, beyond speculative investments, is their and assessing the risk of potential borrowers. Mobile money very high price volatility. The daily standard deviation of the platforms allow unbanked consumers, with basic mobile price of bitcoin in 2017 was $4,077 (https://blockchain.info). phones, to make and receive payments much faster and less This high price volatility makes it very difficult the use crypto- expensively than in the recent past. They also provide the currencies as alternative means of transaction, which could infrastructure and generate the digitalized data that can be be useful for international transfers, especially for unbanked used to create and tailor new financial offerings for the finan- population segments. cially excluded. An example is M-Shwari in Kenya, which lever- ages the mobile money infrastructure and digital information At the center of the policy debate is how this new area of of M-Pesa to make credit-scoring decisions (CGAP 2015). finance should be regulated and supervised. Lending discrimi- Moreover, low-income consumers and SMEs are the user nation against some customers, disclosure requirements for targets of most marketplace lenders, which typically arrange SMEs, and the sharing of customer data are some of the main small loans for these financially constrained segments. Lastly, areas of concern for U.S. regulators with respect to the new one of the benefits of the blockchain technology for financial online platforms (Politico 2016). Moreover, consumer protec- inclusion is its potential to reform and improve property tion and education measures are much needed because many ownership through blockchain registries, which would gener- fintech services serve segments of more vulnerable custom- ate proof of collateral (an important problem in developing ers (some of whom are accessing financial services for the nations) and thus improve access to credit. first time). Another area of concern is the cross-border 3 The Fintech Revolution: A Threat to Global Banking? activity of the new digital financial services. Although many firms in the developing world (where the banking system is fintech companies operate globally or offer digital products often underdeveloped), but also for underserved borrowers involving multiple countries, financial regulation remains in high-income countries (Roure, Pelizzon, and Tasca 2016; region-specific and highly fragmented. Therefore, it is not Blasseg and Koetter 2016). Moreover, because a bank account clear which country’s laws should prevail. is needed to perform many of the fintech services, it would be hard to imagine fintech companies overtaking banks Excessive regulation might not be desirable because it completely and becoming involved in the current accounts could be deadly for fintech start-ups. Understating this trade- niche. There will always be need for a highly regulated service off, regulators in some countries are developing regulatory that allows households and firms to keep their money safe sandboxes to manage the transition to a new landscape. This and accessible. Banks seem to be the players best suited for approach has two aims. On the one hand, it allows fintech that role. companies to live test their services with real customers while facing a low level of regulation during a predefined period. On The trend toward digitalization and technological innova- the other hand, it helps financial authorities better under- tion will likely reshape the global financial sector and the ways stand the functioning of the new services as well as their in which financial companies interact with their customers. advantages and risks, ensuring that appropriate consumer The proliferation of mobile devices, new demographics, and protection safeguards are built into the new products and the rise of fintech providers are the driving forces in this services before they reach the mass market (Financial development, fueling the emergence of new solutions and Conduct Authority 2015). The United Kingdom has launched products that better address customer needs by increasing its sandbox, and other economies, such as Australia, Singa- accessibility, speed, and convenience. As a result, customer pore, and Hong Kong SAR, China, are pursuing similar initia- expectations regarding financial services are increasing, and tives. The sandbox strategy has also been contemplated by banks will find it difficult to control all parts of the value chain U.S. regulators (Wall Street Journal 2016). The new digitally using the traditional business models. enabled methods could also be used to address compliance requirements and to monitor digital financial services Some global banks appear to be shifting their distribution (“regtech”). channels from brick and mortar operations to nonphysical channels, which will probably be the main channel of interac- Outlook and Conclusion tion between banks and consumers in the future. Banks also seem to be shifting toward viewing fintech companies as Despite the rapid expansion of fintech companies, so far, the partners and enablers rather than disruptors and competitors level of disruption seems to have been low. Only about 1 (Economist Intelligence Unit 2015). Incumbents are realizing percent of consumer banking revenue in North America had the need to take advantage of fintech capabilities to grow been disrupted by fintech players by 2016 (Citigroup 2016). business, retain existing customers, and attract new ones, The low level of disruption to date is partly driven by the some of whom were previously unbanked. Meanwhile, complementarity between the services provided by many without access to a client base, client trust, capital, licenses, fintech providers and traditional banks. That is, in many and a robust global infrastructure, the new fintech companies instances, the new fintech companies complement (rather will discover that there are limits to their growth. Collabora- than substitute for) traditional banking, bringing alternative tion between incumbents and new players is already taking sources of external finance to consumers and SMEs. For place, and incumbent financial institutions seem to be example, as mentioned, online lending is an alternative for pouring increasing amount of investments into the fintech the type of borrower usually underserved by traditional sector through fintech acquisitions, investment funds, incuba- banks. This is of special relevance not only for households and tors, and accelerators. References Accenture. 2016. “Fintech and the Evolving Landscape: Landing Points Nakamoto, S. 2008. “Bitcoin: A Peer-to-Peer Electronic Cash System.” for the Industry.” Philippon, T. 2015. “Has the U.S. Finance Industry Become Less Adriano, A., and H. Monroe. 2016. “The Internet of Trust.” Finance and Efficient? On the Theory and Measurement of Financial Development 53 (2). Intermediation.” American Economic Review 105 (4): 1408–38. Blaseg, D., and M. Koetter. 2016. “Friend or Foe? 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