How fintech will eat into banks’ business

“THE DISTINCTIVE function of the banker ‘begins as soon as he uses the money of others’; as long as he uses his own money he is only a capitalist,” wrote Walter Bagehot in 1873, quoting Ricardo. This distinction may seem outdated. Institutional investors (hedge funds, mutual funds, pension funds, private equity) all use other people’s money. Yet Ricardo’s point matters.

Modern institutions are the interface between individuals and their capital. Gains (or losses) are returned to individuals. By investing in this way, people typically deploy their own money, with the fund acting as a mere tool. Banks also use deposits, the money of others, to extend loans. But customers expect to get their deposits back in full: they do not expect to bear the bank’s loan losses in bad years, nor to reap greater rewards in good ones. It is the banks that take both losses and gains.

This process may make banks unstable, but it also gives them a big advantage in financial services, since deposit-taking and lending are complementary. Banks have as a result become providers of any and all financial services that a client needs, from a credit card to a mortgage to investment advice.Yet all these are now under threat. The clout of non-bank financial firms is growing, making the balance-sheets that banks use to support lending less valuable. And tech giants are using the competitive power of their platforms to muscle into banks’ main business. It is as if the entire industry were in a pincer grip that might one day kill it.

Consider such tech apps as Grab in Singapore or Gojek in Indonesia, which both started as ride-hailing services, or Mercado Pago, the financial arm of MercadoLibre, Latin America’s largest e-commerce site. Their model of financial services starts by being a dominant provider of a service that customers use daily. The most advanced examples are AliPay and WeChat Pay in China. Ant Group, the financial offspring of Alibaba, was born out of the fact that shoppers flocking to Alibaba lacked a safe payment method. Alipay was initially just an escrow account to transfer money to sellers after buyers had received their goods, but it was soon launched as an app for mobile use. In 2011 it introduced QR codes for payments, which are trivially easy to generate. Now a shop owner need only display the code to accept money.

This means of payment proliferated, supercharging Alipay’s growth. It has more than 1bn active users and handled $16trn in payments in 2019, nearly 25 times more than PayPal, the biggest online-payment platform outside China. A competitor arrived in 2013 with Tencent, which added a payment function to WeChat, China’s main messaging app. Together the two process some 90% of mobile transactions in China.

The first blow to banks is that both companies earn as little as 0.1% of each transaction, less than banks do from debit cards. Interchange fees around the world have tumbled because of such firms. “It was very lucrative for fintechs to come in and compete these fees away,” says Aakash Rawat of the bank UBS. “In Indonesia they have fallen from 200 basis points to just 70.” But the bigger threat is that payment platforms may become a gateway allowing tech platforms to attract more users. Using data that payment transactions provide, Ant, Grab and Tencent can determine a borrower’s creditworthiness. Ant began consumer lending only in 2014. By 2020 it had already grown to account for about a tenth of the consumer-finance market in China, though regulators are now reining it in.

Banks have traditional ways to assess borrowers’ creditworthiness, such as credit history or current wealth. Often they secure loans against collateral, like homes or cars, minimising the need to monitor an individual borrower. Bob Hope, a comedian, quipped that “a bank is a place that will lend you money if you can prove that you don’t need it.”

Yet as Agustín Carstens, boss of the Bank for International Settlements, a club of central bankers, said in March, “Data can substitute for collateral.” The information that payment platforms have on users is so plentiful and, until recent crackdowns, the restrictions so lax in China, that Markus Brunnermeier, of Princeton University, talks of “an inverse of the information asymmetry”, in which lenders know more about whether borrowers will repay than borrowers themselves. Big tech and fintech firms have lent $450 per head in China, around 2% of total credit, in five years.

As banks found decades ago, there are synergies between loans and other financial products, like asset management and insurance. Ant muscled into asset management in 2013 with the launch of Yu’e Bao, where shoppers with cash in Alipay earn a small return by parking it in a money-market fund. In 2019 Yu’e Bao briefly became the world’s biggest money-market fund by size, before the central bank put pressure on Ant to shrink it.Ant supplemented this with other investment options and also expanded into life, car and health insurance in partnership with other firms.

Tech firms are using their platforms to reverse-engineer banking.This has even caught on in America, where credit-card sweeteners keep users hooked and payments tech has lagged. Enthusiasm for payment platforms has accelerated during the covid-19 pandemic, which forced shoppers online. PayPal has almost doubled in market value over the past year to more than $310bn, making it the world’s most valuable payment platform.

Stripe, a business-payment provider, is now valued at $95bn, making it the largest private tech company in America.Stripe’s success as a business platform suggests it is not just retail banking that might be under threat, but corporate banking as well. The firm won favour with tiny businesses by making it easier to embed payments in their websites. It has expanded into payroll and cash-management services.

Knowledge can be power

Such platforms cannot do everything a bank does, because they do not have a balance-sheet to sustain lending. A bank’s advantage lies in having deposits to exploit, even if they do not know whom they should lend them to. Tech firms’ advantage is that they know whom to lend to, even if they do not have the funds. So some platforms have decided they would like a balance-sheet. Grab, which is about to go public at a valuation of some $40bn, has acquired a banking licence. If many others took this path banks might remain at the heart of the financial system, though the biggest could be Ant, Grab or Mercado Pago, not HSBC, DBS or Santander Brasil.

But most tech firms have opted against banking licences. They are instead skimming the cream off the top. “Core banking”, the heavily regulated, capital-intensive activity of banks, makes around $3trn in revenue worldwide, and generates a 5-6% return on equity (ROE). Payments and product distribution, the business of the tech firms, yields $2.5trn in sales but with a ROE of 20%.

Ant initially made loans and packaged them as securities sold to other financial institutions. But Jack Ma, its founder, fell foul of the government and regulators. So they demanded that originators of securities hold capital against them, trimming Ant’s margins. The firm’s next approach was to act as a conduit, connecting borrowers with banks, which made the loans. But regulators worried that Ant had too little skin in the game, so demanded it hold more capital. Ant must now rethink its business model.

Banks are not the only institutions that may bid for loans or securities that tech platforms want to flog. The balance of power has shifted towards non-banks. According to the Financial Stability Board (FSB), a group of regulators, the capitalists are often bigger players. In 2007 global assets of non-bank financial firms stood at $100trn, equivalent to 172% of gross world output and 46% of total assets. In 2019 these assets, at $200trn, constituted 228% of gross world output and half of the total. “The banking system is smaller, as a share of finance, than it was before,” notes Jamie Dimon, boss of JPMorgan Chase.

Banks still dominate the holding of credit and lending assets. Just shy of 40% of all credit assets, including securities and loans, are held by non-banks, though their share is growing fast. It rose by nearly 9% in 2019, whereas banks’ credit assets grew by just 4.6%. Yet banks remain the largest source of specific loans, holding 83% of global lending assets at the end of 2019.

The switch is most obvious in America, which has a history of capital-market growth as far back as the 1940s, when the pots of money raised by mutual-fund managers swelled. The 1980s brought a rush of debt issuance, especially of junk bonds, by companies. And there was a boom in household debt via securitisation, the bundling of loans into bonds that can be bought and sold. Yet nervousness about securitisation after the financial crash means that now, in America, just 20% of financial assets are on banks’ balance-sheets.

Other countries are following America, not least because regulators want banks to reduce their holdings of risky assets. In the euro area, the share of financial assets held by banks fell from around 60% of the total in 2007 to below 40% in 2019. Much of the world still has a long way to go. “In emerging markets, it is a different story. They are very bank-dependent with very limited capital markets. Some of their capital markets are still in their infancy,” says Carmen Reinhart, chief economist at the World Bank.

The rise of tech firms and capital markets is mostly good news. Access to banks can be costly. Some 7m households in America are unbanked, relying on cheque-cashing firms, pawn shops and payday lenders. Credit and debit cards levy fees of 1-4% on merchants, which are remitted to the rich via air miles and credit-card points. This means that the average cash-using household in effect pays $149 over a year to card users, and each card-using household receives $1,133 from cash users, partly in the form of rewards, said a paper in 2010 by economists at the Federal Reserve Bank of Boston.

New payment systems are also easier to use. UPI in India, which links mobile-phone numbers to biometric data and bank accounts, has helped provide cheaper access to financial services for millions of people. Between 2014 and 2018, 315m previously unbanked Indians have opened accounts, depositing more than 800bn rupees ($12bn), and received 237m debit cards.

Most non-banks do not undertake the maturity and liquidity transformation that makes banks vulnerable to runs. According to the FSB, 29% of the $200trn in assets held by non-bank financial institutions take risks typical of banks, though the share is growing. Most assets are held in investment funds that promise more liquidity. They try to match maturities: a pension fund paying retirement income in 30 years is happy to lock its money up in a private-equity fund for a decade or more.

The triumph of these competitors brings clear benefits, but also some risks. There are economies of scale for both banks and tech firms. Big banks spread the fixed costs of branches and marketing over many customers. Payment platforms spread costs over many users. The value proposition for a customer to join a bank scales with size. A bank can offer cheaper products because it has lots of customers. Yet the value proposition for a payment platform grows exponentially with the network, as each new user makes the system more valuable.

Regulators often complain about concentration in the American banking system, but there are four large banks and thousands of smaller ones. Payment platforms’ comparative advantage makes these businesses more likely to reach a winner-take-all end state (rather like Facebook).

Tech monopolies

Today’s debate over technological monopolists focuses on interoperability, particularly of user data. If online behaviour were able to uncover helpful information about whether a customer qualifies for a loan, it would be more useful if it could be accessed by all potential financial providers. The idea of sharing data in this way, called “open banking”, has already been embraced by regulators in Europe. Another concern could be that platforms might exploit their market dominance to create silos that made it easy to do things within a platform, but well-nigh impossible to use stored money elsewhere.

Regulators in China have turned sharply against its fintech giants. Ant’s troubles began last November when they kiboshed its initial public offering. The firm and its peers are now being forced to retract some credit products, to obtain new business licences and to raise more capital—in short to look and act more like a traditional bank. In Europe regulators are similarly nervous. “The authorities are facing the prospect that an increasing amount of data will be collected through payments for other use,” says Jean-Pierre Landau, a former deputy governor of the Banque de France. “Then it becomes impossible to think of the organisation of payments separately from data priorities, which in Europe are focused on protecting the privacy of individuals.”

The risks from the rise of capital markets are different. It may be that bank balance-sheets will fund a smaller share of lending in future, but as banks are the only institutions that can take deposits their role would not disappear. Yet the arrival of a wider range of participants makes life harder for regulators. In 2007-09 the Federal Reserve intervened in capital markets, but went to much greater lengths to prop up commercial and investment banks. In March 2020, banks went unscathed when capital markets seized up. Rather than acting as lender-of-last-resort only to banks, the Fed became market-maker of last resort, intervening directly in credit markets. The scale of this quantitative easing, to the tune of $23.5 trn, surpasses any other in the Fed’s history. Such efforts to stabilise financial markets make it harder for the Fed to avoid picking winners and influencing credit. As the world changes, regulators’ toolkit will have to adapt.■