FinTech, BigTech, and the Future of Banks
22 Nov, 2019 06:18
source: Harvard Law School Forum
Author: René M. Stulz
Editor’s Note: René M. Stulz is the Everett D. Reese Chair of Banking and Monetary Economics at the Fisher College of Business at The Ohio State University.
Abstract: Banks are unique in that they combine the production of liquid claims with loans. They can replicate most of what FinTech firms can do, but FinTech firms benefit from an uneven playing field in that they are less regulated than banks. The uneven playing field enables non-bank FinTech firms to challenge banks for specific products whose success is not tied to what makes banks unique, but they cannot replace banks as such. In contrast, BigTech firms have unique advantages that banks cannot easily replicate and therefore present a much stronger challenge to established banks in consumer finance and loans to small firms. Both Fintech and BigTech are contributing to a secular trend of banks losing their comparative advantage as they have less access to unique information about parties seeking credit.
In my paper titled FinTech, BigTech, and the Future of Banks, I examine how FinTech and BigTech impact the future of banks. For this article, FinTech is defined as financial innovation based on the use of digital technologies and big data. BigTech firms are “technology companies with established presence in the market for digital services” according to the BIS.
Despite all the excitement about FinTech and the dire warnings about the threat it poses to traditional banks, from 2013 to mid-2019, the Dow-Jones U.S. Banks Index more than doubled and more than held its own with respect to the S&P 500. There is no evidence that the stock market prices bank stocks as if banks were an endangered species. Does this mean that banks can ignore FinTech and BigTech? That they do not represent a competitive threat to banks? That banks are safe from disruption? Or is the stock market just confused about the prospects of banks?
To understand how FinTech and BigTech can threaten banks, it is important to understand whether there is something unique about banks that makes it hard for them to be challenged by non-banks. In the first section of my paper, I argue that banks are indeed special, but some dimensions along which they are special are at risk because of technological developments that predate the digital and big-data revolutions. Banks earn revenues from both sides of their balance sheet as well as by activities that do not show up on their balance sheets. It is best to think of a typical large bank as a large portfolio of synergistic activities. Most of these activities are or could be undertaken by non-banks, so that banks compete with non-banks in these activities. For instance, non-banks make loans to consumers and businesses. However, non-banks do not have demand deposit accounts (though they have substitutes like money market funds), which provide safe and liquid claims that are instantly redeemable. To offer deposit accounts, banks have to have the trust of their customers, which comes in part from access to deposit insurance and to the Federal Reserve’s discount window.
Though banks play a key role in the financial system, they are fragile. Because of the fragility of banks and the potential systemic risk of bank failures, banks are heavily regulated. Bank regulation is expensive, constrains banks, and creates barriers to entry and rapid growth. FinTech firms that do not have a bank charter can compete with banks by offering cheaper and better financial services than those offered by banks in part because they avoid the costs of bank regulation. Whereas regulation makes it difficult for FinTech firms to become successful banks, it benefits them when they compete with banks without acquiring a bank charter. For instance, banks are subject to many regulations that force them to take steps to make sure that their customers are not using their services to launder money. FinTech firms do not have to follow the same regulations. Further, banks are required to hold minimum amounts of capital to satisfy existing regulations. Many bank activities could be carried on with almost no capital, but regulations force banks to hold capital for these activities. FinTech firms are not subject to capital requirements, so they can conduct bank activities at lower cost. Regulation designed to protect the banking system helps FinTech firms at the expense of banks.
Absent regulation, banks could imitate or acquire most FinTech innovations. Large universal banks would have a considerable advantage over FinTech firms if they offered a similar product because they have a huge customer base already. There are at least two obstacles that may hinder their ability to implement FinTech innovations. The Achilles’ heel of large banks is that their IT has been built through add-ons. It relies on parts that use computer languages that most IT people don’t even know anymore. Integrating FinTech innovation into such an IT platform can be problematic or infeasible. That’s where the second obstacle comes in. Large banks are large complex diversified firms where innovation may be impeded because it reduces the profitability or size of existing activities, because of agency conflicts, and because of bureaucracy. These obstacles to the adoption of FinTech ideas by large banks can make it possible for FinTech firms to be successful in challenging banks even without the benefits they have from an uneven regulatory field.
BigTech firms can adopt FinTech innovations much more easily than banks as they already have a digital platform in which these innovations can be incorporated. Further, BigTech firms have a large customer base. As a result, BigTech firms are potentially more of a threat for the future of banks than FinTech firms. At the same time, however, the advantages of BigTech will manifest themselves in consumer finance and lending to SMEs, not in investment banking. After having seen the U.S. banking system evolve towards the universal bank model, we may see it evolve towards a system with large investment or merchant banks and large consumer banks. Such an evolution could be problematic as a strong deposit base was an asset for banks during the global financial crisis and is likely to be so in other periods of stress.
Date Written: September 16, 2019.
The complete paper is available for download here.