Is fintech disrupting the banking sector?
Over the past decade, new digital financial technologies – “fintech” – have begun to transform and disrupt the financial sector. While technological advances in finance are not new, progress has arguably accelerated in the digital age due to improvements in the internet, mobile communications, machine learning, and information gathering and processing technologies.
Fintech spans digital innovations in the financial sector. Notable examples include peer-to-peer lending, equity crowdfunding, cryptocurrencies and the blockchain, digital wealth advisory and trading platforms, and mobile payment systems.
These innovations can disrupt the financial sector by increasing competition and blurring industry boundaries. Fintech provides new gateways to entrepreneurship and credit, and can promote financial inclusion and democratization by giving consumers who are currently excluded from financial services access to stock markets and investment options.
It can also revolutionize how existing firms create and deliver financial products and services as they strive to compete. Consumers in advanced and emerging markets have increasingly adopted fintech services due to their convenience and lower cost (Philippon, 2016; Claessens et al, 2018).
Online lending: challenges for banks and consumer benefits
While fintech companies are emerging across the financial industry, digital innovators are particularly present in the banks’ traditional markets. Online peer-to-peer lending platforms are at the forefront of the fintech revolution. These platforms match borrowers with investors (such as private individuals) online who finance loans instead of traditional finance providers such as banks and construction companies.
A unique feature of peer-to-peer platforms is that they use digital algorithms to screen a borrower’s loan application and determine whether it meets their credit standards. The entire digital lending process is automated so that applicants are not required to speak to a loan officer or visit a bank branch.
Although commercial banks are increasingly relying on similar technologies, they are not digitizing credit processing to the same extent and typically use offline processes and staff to decide whether to lend to a borrower.
Crucially, unlike banks, peer-to-peer lenders do not accept or use deposits to fund loans. Instead, after digital screening of borrowers’ loan applications, these platforms display on an online marketplace the loans that individuals and institutions can decide to invest in.
While investors typically get a higher return on peer-to-peer investments compared to bank deposits, they face losses in cases where a borrower defaults and is unable to repay the loan. Peer-to-peer lending platforms do not invest in loans, but instead receive a fee for each loan they process.
The benefits of peer-to-peer lending to consumers include faster and cheaper access to credit compared to banks (Cornaggia et al, 2018). Peer-to-peer lenders also promote access to credit for individuals and businesses geographically distant from bank branches (Cumming et al, 2021).
Furthermore, digital algorithms are less prone to conscious and unconscious biases than loan officers, which reduces discrimination in lending (Bartlett et al, 2022). But this may be offset by peer-to-peer investors’ preference for financing loans to borrowers with similar characteristics to themselves (Duarte et al, 2012; Iyer et al, 2016).
A key question is whether peer-to-peer lending promotes financial inclusion by expanding access to credit. Early evidence on this question is mixed. Some studies show that marketplaces are a substitute for bank credit, so that digital disruption changes who gives credit rather than increasing the total amount of available credit (Cornaggia et al, 2018).
But other research finds that peer-to-peer lending complements bank lending by expanding access to credit among people to whom banks are unwilling to lend (Tang, 2019).
Peer-to-peer lending appears to have broader economic effects. For example, these platforms are able to meet borrowers’ credit needs quickly during crises (Yang et al, 2016). Restricting access to peer-to-peer lending increases household financial hardship and the incidence of personal bankruptcy, especially among low-income households (Danisewicz and Elard, 2018).
Regions with access to more peer-to-peer credit have a higher degree of entrepreneurship and business creation. For example, in the United States, a 10% increase in peer-to-peer lending (per capita) increases the number of businesses (per capita) by 0.44%.
But most of these new business ventures tend to be small businesses with fewer than five employees because peer-to-peer lending is usually limited to small amounts. These businesses are also mainly in traditional industries (eg convenience stores) where the costs of setting up a firm are low (Cumming et al, 2021).
Payment services and cryptocurrencies
Another area where fintech has made inroads into the banks’ market share is payment services – in other words, the transfer of money between accounts. The payment market has experienced a rapid spread of digital innovations that make payments faster and cashless.
In particular, banks face competition from fintech companies such as PayPal, Revolut and Wise, as well as major technology companies including Meta, Apple and Google. The rapid growth of digital payments has provoked a drop in consumer demand for cash (Rogoff, 2014). Digital payments represent the largest component of fintech by transaction volume (Thakor, 2020).
Digital currencies have the most significant disruptive potential for fintech in payment services. Cryptocurrencies are decentralized peer-to-peer digital currencies based on computer cryptography for security (Dandapani, 2017).
A cryptocurrency is not real money that exists. Rather, it is a virtual currency that relies on a digital ledger, known as the blockchain, to replace a bank’s role in securing and verifying transactions (Thakor, 2020). Well-known examples include Bitcoin and Ethereum.
So far, the uptake and use of cryptocurrencies has been relatively limited, even in El Salvador where Bitcoin is now formal tender. In part, this is due to volatility in cryptocurrencies’ values, which limits their ability to function as a store of value.
Another limitation is the ability of cryptocurrency networks to process transactions, which determine how useful a currency is. For example, Bitcoin processes approximately seven transactions per second. In contrast, for Visa and Mastercard, the values are 24,000 and 5,000 respectively.
Cryptocurrencies also have far-reaching environmental effects. Bitcoin mining consumes more electricity than Finland and Belgium, and produces a carbon footprint capable of pushing global warming beyond 2°C over the next three decades (Mora et al, 2018).
Additionally, as one of the largest unregulated markets in the world – along with the anonymity of blockchain transactions – cryptocurrencies have become important within the black market. About 25% of Bitcoin users are involved in illegal activity and $76 billion of illegal activity per year involves Bitcoin, equivalent to 46% of Bitcoin transactions. This is close to the scale of American and European markets for illegal drugs.
How have the banks reacted to fintech?
The fintech revolution has provoked important changes among banks. They have responded to the rise of peer-to-peer lenders and fintech rivals by adopting digital innovations such as smart chips, biometric sensors, branchless banking, artificial intelligence and machine learning to protect against fraud.
They have also introduced chatbots, e-wallets and m-banking, which have enabled them to offer safer and more user-friendly customer services. Banks’ use of fintech solutions is partly driven by imitation of fintech rivals’ products and services, and by buying up these companies to gain ownership of their technologies and intellectual property (Thakor, 2020). For example, JP Morgan Chase acquired InstaMed to strengthen its healthcare payment solutions; and Goldman Sachs acquired NextCapital, a retirement robo-advisor, to drive their expanding asset and wealth management business toward retirement program construction.
Will fintech disrupt the financial sector?
As fintech companies take market share from traditional banks and other financial services firms, they pose a potential threat to the stability of the financial sector by eroding profits and increasing operating costs.
Evidence on this issue remains relatively sparse, although research indicates that competition between peer-to-peer lenders and banks for money to fund loans can destabilize the banking sector. This occurs as the cost of deposits increases, forcing banks to rely more heavily on riskier forms of debt, although the magnitude of these effects is modest (Cumming et al, 2022).
Despite interventions in the banks’ activities, and exponential growth over the past decade, the fintech sector is still small compared to the banking sector. For example, while global fintech activity reached around $210 billion in 2021, the size of global financial services in the same year was $23,319.52 billion (see Figure 1).
Even in the lending market, fintech’s reach remains small. For example, the total amount of credit from peer-to-peer lenders in the UK in 2021 was £4 billion compared to £316 billion from banks. Similar patterns exist elsewhere, although peer-to-peer lending is more important in China and Japan than in other countries.
Figure 1: Total global investment activity in fintech
Source: Pulse of fintech, KPMG International
Regulation and public order
Banks are heavily regulated, in part because of their size and deposit taking. So far, fintech credit providers are generally outside this regulatory and reporting framework. To the extent that fintech companies are regulated, they can be drawn into either existing or new regulatory frameworks.
An important guiding principle is likely to be ‘neutrality’: ensuring that regulation does not disproportionately favor one entity or form of activity over another, provided the risks are equal (Bank for International Settlements, BIS, 2018).
For example, in the US, peer-to-peer lenders must document that they are able to prevent fraud in borrowers’ credit applications to protect investors from losses. But regulators have also sought to minimize the regulatory burden to promote innovation, market entry and competition.
Recent events in the cryptocurrency markets have raised questions about the regulation of digital currencies due to their black market use, environmental impact from mining activity and “pump-and-dump” schemes that hurt investors.
Cryptocurrencies can be an important tool for avoiding taxes, regulations and capital controls. This is particularly problematic in emerging economies, which have limited institutions to curb this behavior. To date, China is the only country to declare all cryptocurrency transactions illegal.
Such measures are unlikely to have a significant effect on the banks. Rather, the remarkable growth of fintech firms in domestic and international payment services is a greater threat to their market share in this industry.
Where can I find out more?
- What is fintech? An overview of fintech, fintech companies, regulations and the future by Stephanie Walden.
- The role of peer-to-peer lending in fintech: An overview of peer-to-peer lending and its future by Vijay Kanade.
- Understanding cryptocurrencies: An article in a leading financial journal by Wolfgang Karl Härdle, Campbell Harvey and Raphael Reule, which provides insight into the mechanics of cryptocurrencies.
- Sex, drugs and Bitcoin: how much illegal activity is financed through cryptocurrencies? An article in a leading financial journal by Sean Foley, Jonathan Karlsen and T?lis Putni?š, estimating the extent of illegal activity involving Bitcoin.
- The digital credit divide: marketplace lending and entrepreneurship: A leading finance journal article by Douglas Cumming, Sofia Johan, Hisham Farag and Danny McGowan, estimating the effect of peer-to-peer lending on business creation.
Who are the experts on this question?
- Douglas Cumming
- Piotr Danisewicz
- Santosh Koirala
- Danny McGowan
- Biwesh Neupane
- Andrew Urquhart
Authors: Santosh Koirala, Danny McGowan and Biwesh Neupane
