Fintech and Banking

In a recent paper, I review the literature on fintech and its interaction with banking. Included in fintech are innovations in payment systems (including cryptocurrencies), credit markets (including peer-to-peer or “P2P” lending), and insurance, with blockchain-assisted smart contracts playing a role. My review paper defines fintech, examines the stylized facts, and then reviews the theoretical and empirical literature. The paper summarizes our knowledge on the main research  questions raised by the literature review and concludes with questions for future research.

Fintech is a hot topic, even though the interplay between information technology and financial services is not a new topic. For example, 20 years ago, in a discussion of consolidation in financial services, I concluded with the observation that the ongoing consolidation at that time was likely to be followed by specialization-induced fragmentation in the financial services industry.  I conjectured that information technology would encourage the emergence of specialized players creating an ever-increasing set of market niches with greater product customization to cater to customer preferences. In a sense, this is what we are observing today. Non-intermediated P2P lending, cryptocurrencies, and smart contracts are all parts of an emerging new mosaic of technology-assisted customized financial services. Perhaps one aspect of this development that is somewhat unprecedented and hence surprising is the extent to which these developments involve non-intermediated transactions.  One reason why fintech is generating so much research interest is that it is bypassing traditional intermediaries in the offering of financial services. Thus, the estimated 12,000 or so specialized fintech firms potentially present an existential threat to traditional financial intermediation, and some have wondered if fintech is the new paradigm for financial services that will make traditional banking obsolete.

What do these developments portend for the future of banking, financial markets, and payments systems?

My paper addresses this question and discusses the different aspects of the development of fintech, examining issues that are raised by these developments with respect to banking.

At its core, fintech is the use of technology to provide new and improved financial services. Part of the motivation for the emergence of fintech is that, while information technology has made everything from computers to cars cheaper and more functional, the unit cost of financial intermediation – intermediation income as a percentage of intermediated assets – has not changed much in over a century. Thus, one promise of fintech is the unveiling of cheaper ways to overcome financial contracting frictions and lower the cost of financial services to improve consumer welfare.

The Financial Stability Board (FSB) defines fintech as “technologically enabled financial innovation that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions and the provision of financial services.” This definition has also been adopted by the Basel Committee on Banking Supervision (BCBS), in part because “This broad definition is considered useful by the BCBS in light of the current fluidity of fintech developments.”

The areas that fintech covers can be classified as: (i) credit, deposits, and capital-raising services; (ii) payments, clearing, and settlement services, including digital currencies; (iii) investment management services (including trading); and (iv) insurance. Part of the technological backbone of fintech is the blockchain technology. Fintech is influencing the conduct of transactions in all four aspects. The biggest impact of fintech is currently in areas (i) and (ii). Its impact on (iii) and (iv) is expected to  grow in the future.

As Apple Pay offers a virtual wallet, P2P lending platforms offer an alternative to bank loans, and cryptocurrencies like Bitcoin provide a non-fiat-money-based currency alternative to cash, numerous profoundly important questions arise that may prove to have substantial research legs and policy implications.

My review of the literature leads to three major conclusions:

  • First, P2P lending will take some market share away from banks, but will not replace bank lending in the near future. P2P lenders are likely to take riskiest borrowers, as well as borrowers who lack collateral, away from capital-constrained banks. This loss of business is less likely when banks are well capitalized. In the long run, banks will either build their own online lending platforms, acquire P2P platforms, or partner with P2P platforms. That is, rather than threaten banking, fintech will alter the way banking is conducted. Bank deposit gathering and lending are here to stay.
  • Second, cryptocurrencies will grow in popularity but will not replace fiat currency. It is likely that central bank digital currencies – which are centralized rather than being decentralized like Bitcoin – will emerge in the future as fiat currencies to replace cash.
  • Third, Fintech will significantly affect trading and insurance. Smart contracts are likely to substantially impact financial contracting. The consequence will be more precise risk-based pricing and contract innovations.

This post comes to us from Professor Anjan V. Thakor at Washington University, St. Louis’ John M. Olin School of Business. It is based on his recent article, “Fintech and Banking,” available here.

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