I. Introduction
OECD's newly-published paper titled "Digital Disruption in Banking and its Impact on Competition"1 analyses the possible strategies of the players involved—incumbents, FinTech and BigTech firms—and the role of regulation. In its paper, OECD states that the industry is facing radical transformation and restructuring, as well as a move toward a customer-centric platform-based model. According to OECD, competition will increase as new players enter the industry, but the long-term impact is more open, and regulation shall decisively influence to what extent BigTech shall enter the industry and who shall be the dominant players. Pursuant to OECD's view, the challenge for regulators will be to keep a level playing field that strikes the right balance between fostering innovation and preserving financial stability where the consumer protection concerns rise to the forefront.
In this executive summary, highlights of OECD's "Digital Disruption in Banking and its Impact on Competition" paper shall be presented. Firstly, the report lists the current supply and demand drivers within the field of financial services which have been transformed due to the digital disruption. Then, OECD makes a comparison between FinTechs, BigTechs and banks by their advantages and disadvantages while keeping in mind the "effectiveness" criterion. After analysing the current situation between these stakeholders, OECD puts on table whether the dynamics between them should be competitive or more tend to co-operation. Following this section, relation between competition and regulation is discussed by OECD. Lastly, financial stability implications of this digital disruption are presented. OECD has specified several sources of risk which have emerged with the entry of FinTech and BigTech firms into the banking sector.
II. Supply and Demand Drivers of Digital Disruption
OECD underlines the fact that the digital disruption in the financial sector is driven by factors both on the supply side -mostly technological developments- and on the demand side, accompanied by changes in consumer expectations of service.
OECD lists and makes comment on relevant factors on the technological supply side as follows; (a) APIs enable software applications to share data and functionality and represent a remedy for markets with high switching costs, increasing contestability as they help consumers compare product and service offers, (b) cloud computing has been used for customer relationship management, human resources, and financial accounting and is being tested for use in consumer payments, credit scoring, statements, and billing. Both APIs and cloud computing, if not securely managed or properly monitored, can give rise to new risks, endangering market structure stability, (c) smartphones capture the client interface with multiple functions including payments (i.e., digital wallets), money transfers, and online shopping. Digital wallets are among the fastest growing technology markets, (d) digital currencies may threaten the banking sector with disintermediation if substantial retail deposits were to move to e-money providers. In that case, a crucial issue will be whether e-money providers will have access to central bank reserves, deposit insurance, and/or the lender of last resort, (e) blockchain technology provides a means to achieve a decentralized consensus and may enlarge the space of potential contracts with so-called smart contracts, which can be enforced without the need for a third party.
According to OECD, demand-side drivers are linked to the greater service expectations of the mobile generation and higher customer expectations result from the digitization of commerce and the real-time transacting capability of internet-connected devices offering greater convenience, higher speed, and better user-friendliness of financial services employed by Uber, Amazon, and the like.
OECD expresses that the digital revolution has changed the demand for financial services and led the sector to become more customer centric and on the supply side, it has left incumbents with obsolete technologies, such as an overreliance on rigid mainframes, and an overextended branch network.
III. FinTech & Efficiency
OECD sets forth that FinTech (a) can more effectively screen candidate borrowers via statistical models based on big data, (b) reduces the need for personnel since customers use their mobile phones for banking, (c) allows much more targeted price discrimination, (d) can increase financial inclusion by opening the door to financial services for less developed countries as well as segments of the population and small and medium-sized enterprises (SMEs) currently unserved or underserved by banks, (e) have no legacy technologies to deal with and are characterized by a culture of efficient operational design and Fintech can benefit from designing systems in the cloud from scratch instead of having to work on top of legacy IT systems. According to OECD these are the ways of Fintech that drives efficiency. OECD also set forth the advantages and disadvantages of Fintech and BigTech firms as follows;
Fintech's Advantages and Disadvantages:
· Advantages: (i) Superior technology free of legacy systems; leaner operation, (ii) Friendly consumer interface and new standard of consumer experience, (iii) Focus on activities/business segments with higher returns on investment, (iv) More equity funding and (v) Ability to attract best talent.
· Disadvantages: (i) Absence of an installed, loyal customer base, (ii) Limited access to soft information, (iii) Lack of reputation and brand recognition, (iv) High cost of capital and small balance sheet and (v) Lack of regulatory and risk management experience and expertise; lack of access to the central bank backstop without a banking license.
BigTech's Advantages and Disadvantages:
· Advantages: (i) Established, loyal customer base, (ii) Ability exploit network effects, (iii) Superior technology free of legacy systems; leaner operation, (iv) Valuable business data, (v) Friendly consumer interface and new standard of consumer experience, (vi) Large quantities of customer data, (vii) Strong brand names, a strong reputation and lobbying capacity, (viii) Focus on activities/business segments with higher returns on investment and (ix) Capability to fund their activities with a low cost of capital, (x) Economies of scale and scope and (xi) Ability to attract best talent.
· Disadvantages: (i), Lack of regulatory and risk management experience and expertise; lack of access to the central bank backstop without a banking license.
Bank's Advantages and Disadvantages:
· Advantages: (i) Economies of scope, (ii) Specialized unique banking products and services, (iii) Greater client trust and security, (iv) Better ability to navigate the regulatory maze, (v) Similar lobby power than BigTech firms and (vi) Regulatory and risk management experience and expertise; access to the central bank backstop without a banking license.
· Disadvantages: (i) Rigid legacy system and (ii) Millennials' mistrust.
As the conclusion, OECD asserts that BigTech companies are potentially much more disruptive to the traditional banking business burdened by legacy systems.
IV. Competition or Co-operation Between Incumbents and New Entrants
OECD states that on the supply side, new competitors are able to use hard (codifiable) information to erode the relationship between bank and customer, which is commonly based on soft information (derived from the knowledge gained from the relationship between bank and customer) and on the demand side, new entrants try to profit from millennials' mistrust of banks by offering digital services. Furthermore, strict regulations for banks (e.g. enhanced capital requirements) are moving activity to the shadow bank sector, and an increasing proportion of nonbanks are digital, according to OECD.
From OECD's perspective, incumbents' strategies against FinTech could be either accommodating their entry or fighting with them/ trying to prevent their entry. OECD suggests that incumbent bank may benefit from high switching cost for customers and interchange fees from new service operators while accommodating Fintech entry. On the other hand, OECD points out that if incumbents decide to compete or prevent FinTech entries, they may launch their own fully online banks or shut down/degrade access to infrastructure. FinTech strategy against the incumbents could be either committing to remain small or entering to market as a licensed digital bank. FinTech could be occupied with person-to-person lending that serves unbanked segments of population or form partnership with incumbents if they commit themselves to remain small. OECD suggests that the entry of FinTech into the market as a licensed digital bank is less likely given the high compliance costs involved therefore consolidation with or selling to incumbents would be more likely.
Unlike the incumbents' abovementioned strategy on accommodating FinTech entry, OECD states that if incumbents decide to accommodate the entry of BigTech firms, they could only form partnership with BigTech firms or focus on providing specialized unique banking products and services. OECD sets forth that if incumbents decide to compete head to head with BigTech firms they could become platform/marketplace and try to profit from superior trust from customers and data security, rely on better regulatory navigation skills and similar lobby power than BigTech firms however despite enjoying some network effects they could not match BigTech firms' bundling/cross-subsidization strategy with complementary financial and nonfinancial products. On the other hand BigTech firms could form partnerships as well with the incumbents or could decide to compete with the incumbents and become banks/intermediaries bundling their offerings and exploiting economies of scope (opt not to accept deposits to avoid regulation), monopolize the interface with customers by controlling loan origination and the distribution business or form a multiplatform bundle, according to OECD.
OECD points out that in any case, the strategies of both incumbents and entrants will be conditioned by regulation. As an example, United Kingdom has developed an environment to facilitate the entry of FinTech firms and mobile-only neo-banks with a single regulator -the Financial Conduct Authority (FCA)- via sandbox. Open banking also contributes to this environment. In the United States, by contrast, there are more barriers (fragmented regulators and rules that imply the need to have physical branches as facilitated entry to the market). Another example may be Singapore whose government has pushed incumbents to upgrade digitally.
OECD asserts that BigTech firms are likely to lead to increased competition, but in the long run this effect could be reversed if they dominate the customer interface because in markets with network externalities, once an operator has attained a critical market share—a tipping point—it may gain dominance and history has shown that when BigTech firms enter industries with long vertical value chains, they may use their comparative advantage to monopolize the segments where they operate and then expand their monopoly power to other layers of business through network effects.
According to OECD, an early effect of digital disruption will be the erosion of incumbents' margins and an increase in competitive pressure and contestability of banking markets but the long-run impact will depend on the extent of BigTech firms' entry into the market and on whether several firms (perhaps including some platform-transformed incumbents) manage to monopolize the interface with customers and appropriate the rents in the business. Finally, OECD sets forth that in any event, incumbents will have to restructure, and the current overcapacity, together with the need to invest heavily in IT in a low-profitability environment, shall lead to consolidation.
V. Competition and the Role of Regulation
OECD stresses that the main issue in regulating BigTech and FinTech is to decide whether regulation should aim at a level playing field or whether it should favor entrants in order to promote competition. In this context, previous regulation initiatives such as the Financial Conduct Authority in UK, EU Payment Services Directive II, Japan Banking Act and Canadian Competition Bureau) have been given as examples, and it is stated that all these approaches shall influence the type of competition between incumbents and new entrants. OECD also underlines that the policies implying asymmetric regulation could augment contestability in short term; however, it will need to be balanced given that there is a potential long-term risk of monopolization by BigTech.
Consequently, regulatory authorities will have to determine who shall bear the burden of operational and security risks, as well as regulatory compliance. In this regard, the view of European Banking Authority has been conveyed which set forth that regulatory structure aims to impose the same rules on activities of similar levels of risk. However, the OECD has stated that determining the risk level of activities can be a challenge for the regulators since it can be achieved through monitoring innovation, assessing risks in relation to the public interest, and making selective use of the existing rulebook. In contrast, OECD has emphasized that it is entities, not activities, that are subject to failure and may generate systemic risk.
Last but not least, new approaches such as regulatory sandbox and RegTech are mentioned as they may answer regulatory authorities' questions, and issues as consumer protection and cross-border asymmetries have been conveyed as what regulatory authorities must keep in mind during their regulatory activities.
Footnote
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