Working Paper Series Financial intermediation and technology: Whats old, whats new? Discussion Papers Arnoud Boot, Peter Hoffmann, Luc Laeven, Lev Ratnovski Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB. No 2438 / July 2020Discussion papers Discussion papers are research-based papers on policy relevant topics. They are singled out from standard Working Papers in that they offer a broader and more balanced perspective. While being partly based on original research, they place the analysis in the wider context of the literature on the topic. They also consider explicitly the policy perspective, with a view to develop a number of key policy messages. Their format offers the advantage that alternative analyses and perspectives can be combined, including theoretical and empirical work. Discussion papers are written in a style that is more broadly accessible compared to standard Working Papers. They are light on formulas and regression tables, at least in the main text. The selection and distribution of discussion papers are subject to the approval of the Director General of the Directorate General Research. ECB Working Paper Series No 2438 / July 2020 1Abstract Westudytheeffectsoftechnologicalchangeonfinancialintermediation,distinguishingbetween innovationsininformation(datacollectionandprocessing)andcommunication(relationshipsand distribution).Bothfollowhistorictrendstowardsanincreaseduseofhardinformationandlessin personinteraction,whichareacceleratingrapidly.Wepointtomorerecentinnovations,suchasthe combinationofdataabundanceandartificialintelligence,andtheriseofdigitalplatforms.Weargue thatinparticulartheriseofnewcommunicationchannelscanleadtotheverticalandhorizontal disintegrationofthetraditionalbankbusinessmodel.Specializedprovidersoffinancialservicescan chipawayactivitiesthatdonotrelyonaccesstobalancesheets,whileplatformscaninterject themselvesbetweenbanksandcustomers.Wediscusslimitationstothesechallenges,andthe resultingpolicyimplications. JELCodes:G20,G21,E58,O33 Keywords:FinancialIntermediation,FinancialInnovation,Fintech,Information,Communication ECB Working Paper Series No 2438 / July 2020 2Non Technical Summary Technologicalchangeinthefinancialindustryisaccelerating,drivenbydataabundanceandthe emergenceofdigitaldistributionchannels.Incumbentinstitutionsfacecompetitionfrom technologyorientedfinancialstartups,anddigitalplatformsaremakingtheirfirstventuresinto finance.Ifanything,theCOVID19crisiscanspeedupthistechnologicaltransformationthrough increaseddemandfordigitalservices.Thistrendraisessomeimportantquestions.Whatarethekey dimensionsofinnovationintheprovisionoffinancialservices?Aretheygenuinelynew developments,orratherthecontinuationofoldtrends?Whatwillbetheimpactonfinancial industrystructure?Howshouldpublicpolicyadjust? Thispaperproposesasimpleconceptualframeworktoanswerthesequestions.Weidentifytwokey ingredientsoffinancialintermediationinformation(datacollectionandprocessing)and communication(relationshipsanddistribution)anddescribehowtheyareaffectedbyinnovation. Further,wedistinguishbetweenestablishedtrendsintechnologicalinnovations,suchastheriseof creditscoringandthedemiseofbranchbanking,andmorerecentdevelopments,suchasthe incorporationofnonfinancialdataandartificialintelligenceinfinancialdecisionmaking,andtheuse ofdigitalplatformsandmobiledevicesforthedistributionoffinancialservices. Existingliteraturesuggeststhattherelianceon“hardinformation”increasescompetitionandlowers costsinthefinancialindustry.Atthesametime,itcanleadtoamorecyclicalfinancialsystem,and givesrisetoincentiveproblems.Whiletheroleofinnovationsincommunicationhasbeenstudies less,wearguethattheywillbepivotalfordeterminingfuturefinancialindustrystructure.Digital distributionchannelsenabletheentryofspecializedprovidersoffinancialservicesthatcansidestep banksestablisheddistributionnetworksandchipawayactivitiesthatdonotrequireaccesstoa largebalancesheet,suchaspaymentsandwealthmanagement.Similarly,digitalplatformscan interjectthemselvesbetweenbanksandcustomers,collectingmostrentsandpotentially monopolizingaccesstodata.Asaconsequence,bankslosetheirpositionas“firstpointofcontact” forfinancialservices.Intheextreme,theuniversalbankbusinessmodelmaydisintegrateand reducebankstobeingupstreamsuppliersofmaturitytransformationservicesthathavenodirect customeraccess. However,therearesomeforcesthatwilllimit,oratleastdelay,thetransitiontothisnew environment.Specializedstartupsfacefinancialconstraintsandtheirgrowthislimitedbytheir focusedbusinessmodels.Moreover,digitalplatformstypicallyfocusonretailcustomers.Thislimits theirreachintheprovisionoffinancialservices,andallowsbankstomaintaintheircompetitive ECB Working Paper Series No 2438 / July 2020 3positionvisviscorporateclients.However,thismaychangewiththeincreasingadoptionofcloud computing,whichcansupportdigitalecosystemsforthecorporatesector. Finally,wediscusspolicyprioritiesinfourareas.Prudentialpolicywillneedtokeepupwithnew digitalbusinessprocesses,whichcangiverisetonewrisks.Similarly,monetarypolicywillneedto adjusttooperatinginafinancialsystemthatisnotbankcentric,andmoreprocyclicalpetition policywillneedtofindwaysforaddressingtheroleofdigitalplatformsascommunicationgateways formaintainingalevelplayingfield,whiledatapolicyiskeytoachievingoptimaloutcomesindata collection,exchange,andprivacy. ECB Working Paper Series No 2438 / July 2020 41 Introduction Thepastdecadehaspresentedmassivechallengestofinancialinstitutions,includingthegreat financialcrisis,regulatoryreform,lowprofitability,anddeterioratingpublictrust.Againstthis background,technologicalchangeinthefinancialindustryisaccelerating.TheongoingCOVID19 crisis,whichhasincreaseddemandfordigitalservices,isifanythingspeedingupthisprocess. Incumbentsfacedisruptionfrominnovativestartupsandlargetechnologyfirms.Thisraisesa numberofimportantissues.Whatarethekeydimensionsofinnovationintheprovisionoffinancial services?Aretheygenuinelynewdevelopments,orratherthecontinuationofpasttrends? Answeringthesequestionsiscrucialforanticipatingfuturechangesinthefinancialsystem,gauging theirimpactonincumbentinstitutions,anddistillingpublicpolicypriorities. Inthispaper,wedevelopasimpleconceptualframeworkthatdistinguishesbetweentwokey dimensionsoffinancialinnovation,information(datacollectionandprocessing)andcommunication (relationshipsanddistribution).Wearguethatbotharekeyingredientsinthefinancial intermediationprocess,andallowbankstoexertmarketpowerthroughinformationalandspatial capture.Bothareaffectedbytechnologicalchange.Weidentifytheproliferationofhardinformation andtheshiftawayfrominpersoninteractionsaslongstandingdevelopments.Theexisting literatureoffersusefulinsightsthatremainvalidinanenvironmentwherethoseforcesare accelerating. Wecontrastthecontinuationofpasttrendswithmorenoveldevelopments,suchastheriseof machinelearningandartificialintelligenceenabledbyanabundanceof(nonfinancial)data,andthe dominanceofdigitalplatformsandsmartphones.Wearguethattechnologicalprogressmayleadto theverticalandhorizontaldisintegrationofthetraditionalbankbusinessmodel.Novel communicationchannelsenablespecializedproviderstosidestepbanksdistributionnetworksand offerfinancialservicesthatdonotrequireaccesstoabalancesheet,forexampleintheareasof paymentsandwealthmanagement.Moreover,digitalplatformscaninterjectthemselvesbetween banksandtheircustomers,introducinganotherlayerofintermediationthatcapturesmostrents.In theextreme,thiswouldrelegatebankstoupstreamprovidersofmaturitytransformationservices. Wealsodiscusslimitationstotheentryofspecializedfinancialserviceprovidersanddigital platforms.Standaloneprovidersofspecializedservicesareconstrainedbytheirnarrowbusiness modelsandthefactthattheyrarelypossessadeepbalancesheet.Whilelargedigitalplatformshave deeppockets,theirreachintheprovisionoffinancialservicesisconstrainedbytheirfocuson servingretailconsumers.Thismaychange,however,duetotheriseofcloudcomputing,whichmay enablelargetechnologyfirmstocreateB2Becosystemsthatincludelargecorporatecustomers.This ECB Working Paper Series No 2438 / July 2020 5willlikelygivetechnologyfirmsinformationandcommunicationadvantagesfortheprovisionof financialservicestotheseclientsaswell.Bankscanattempttostaveoffthecompetitivepressures fromplatformsandspecializedentrantsbyinvestinginthedigitalizationofownbusinessprocesses. However,besidesbeingcostly,suchtransformationisoftenimpededbyentrenchedorganizational cultures,reputationalrisks,andregulatoryfactors. Ourpapercontributestotheliteratureontechnologicaldisruptioninfinance.Claessensatal.(2018) documenttheriseofFintechlendingacrosscountries,whileThakor(2019)comparescredit provisionbybanksandnonbanks.TheoverviewofVives(2019)highlightsthecompetitivechallenge fromlargetechnologyfirmsanditsimpactonbusinessstrategies,whereasPetraliaetal.(2019)and Stulz(2019)discusstheimpactofFintechandBigtechonbankingparedtothisliterature,our analysisfocusesonarticulatingthekeydimensionsoffinancialinnovationinformationand communicationandondistinguishingpreexistingtrendsfromgenuinelynewdevelopmentsin eachofthesetwodimensions.Thishelpsusclarifytheeconomicforcesatplay,andrefinethe resultingpolicyimplications. Theremainderofthepaperproceedsasfollows.Section2introducesouranalyticalframeworkand brieflydiscussestherolesofinformationandcommunicationforfinancialservicesprovision. Sections3and4discusstheeffectsofinnovationineachofthesefields,respectively,distinguishing betweenthecontinuationofpasttrendsandgenuinelynewdevelopments.Section5highlightsthe horizontalandverticaldisintegrationoftheintegratedbankbusinessmodelasamajorthreatposed byrecentinnovation.WediscusstheresultingpolicyimplicationsinSection6,followedbythe conclusion. 2.Financial intermediation and technological progress Inthissection,wedevelopasimpleconceptualframeworktoguideouranalysis.Wearguethat informationandcommunicationlieattheheartoffinancialintermediation,andaredeeplyaffected bytechnology. The role ofinformation and communication in financial intermediation Thefunctionofthefinancialsystemistotransformsavingsintoinvestment,whichhelpstoensure anefficientallocationofresourcesintheeconomy.Financialintermediariesfocusonovercoming information(moralhazardandadverseselection)andcommunication(“matchmaking”)frictions thatcanpreventtheefficientallocationofresources. ECB Working Paper Series No 2438 / July 2020 6Toresolveinformationalfrictions,financialintermediariesscreenandmonitorriskyinvestmentson behalfofthesaverswholackowncapacitytodoso(Diamond,1984).Bankscommittoexerting effortbyusingtheirfinancialcapital,or“skininthegame”(HlmstromandTirole,1997).Other financialintermediaries,suchasratingsagencies,usetheirreputationtoachievesimilar commitment(Bootetal.,1993).Securitiesunderwritersusebothreputationalandfinancial exposuretoassurecustomersofthequalityoftheirduediligence.Also,financialintermediariestend toengageinrepeatedinteractionswiththeircustomers.Thisfacilitatesthecollection,processing, andreuseofcustomerinformation(Boot,2000),andincreasestheefficiencyofmonitoring(Lopez Espinozaetal.,2017). Toresolvecommunicationfrictions,financialintermediariesinvestinthecreationandmaintenance ofcustomerrelationshipsandproductdistributionchannels.Bankshavehistoricallyleveragedupon theirbranchnetworkstoactasthecustomers“firstpointofcontact”forfinancialservices.Other financialintermediariessuchasbrokersandexchangesspecializeincommunicationtofacilitate matchmakingamonginterestedparties.Theroleofcommunicationinfinancialintermediationhas receivedlessattentionintheliteraturehistorically.Inthispaperwearguethattheroleof communicationindeterminingtheindustrystructureofthefinancialsectorhasbeengrowing,and maynoweclipsethatofinformation. Superiorinformationandcommunicationenablefinancialintermediariestoexertmarketpower. Privateinformationgeneratesinformationalcaptureasoutsidecompetitorsfaceadverseselection (Rajan,1992).Similarly,search,switching,andtransportationcostsleadtocommunicationrelated “spatial”capture,whichallowsbankstopricediscriminateamongcustomers(DegryseandOngena, 2005;AgarwalandHauswald,2010;ArmstrongandVickers,2019),crossselladditionalfinancial services(PuriandRocholl,2008),andenjoycheapandstabledepositfunding(Drechsleretal., 2018). Sinceinformationandcommunicationfrictionsactasbarrierstoentry,theymakefinancialservices provisionlesscontestable.Atthesametime,theypermitfinancialintermediariestogenerate chartervalue,whichmakesthemmorestableandforwardlooking.This,inturn,canbenefit customers.Forexample,bankstendtocushioncredittermsfortheirlongtermcustomersduring downturns(PetersenandRajan,1995;Boltonetal.,2018). Conceptual framework Innovationininformationandcommunicationhasbeenacceleratingoverthepastdecades,driven bygrowingcomputingpowerandtheproliferationoftheinternet.Whiletheunderlying ECB Working Paper Series No 2438 / July 2020 7technologicalprogressisaffectingvirtuallyallsectorsoftheeconomy,theeffectsonfinancial intermediationareparticularlyprofound.ThisisillustratedbyFigure1.TheleftPanelisbasedonthe EuropeanWorkingConditionsSurvey,andshowsthatFinancialIntermediation(blueline)dwarfsall otherindustries(rangeindicatedbyshadedarea)intheuseofpersonalcomputers.In2015,89%of allemployeesinfinancialintermediationmadeheavyuseofpersonalcomputersintheEU15 countries.Therightpanelshowsthattheincreaseofautomationhasledtoasteadydeclineinthe numberofemployeesinfinancialintermediation.Between1997and2018,thenumberofbank employeesdeclinedfrom7,300to5,500permillioninhabitantsintheEU15,correspondingtoa declineofroughlyhalfamillionjobs. Figure1puteruseandemploymentinfinancialintermediation. Note.TheleftPanelshowstheshareofemployeesthatreportusingcomputeratwork,acrrossNACE1sectors.Thebluelineshowsthe shareforFinancialIntermediation,whiletheshadedgreyareaindicatestherangeforothersectors.Source:EuropeanWorkingConditions Survey.TherightPanelshowsthenumberofbankemployeespermillioninhabitants.Source:ECBStatisticalDataWarehouse.Alldata coverEU15countries Thefinancialindustryhasexperiencedmanywavesoftechnologicalinnovation.Advancesonthe informationsideledtotheriseofpassiveinvestinginthe1980sandtothecreditscoringand securitizationrevolutioninthe1990s.Similarly,innovationsincommunicationincludedATMsinthe 1970s;telephonebankinginthe1980s;attemptedentryintobankingbysupermarketgiants WalmartandTescoinUKinthe1990s;andtheincreaseduseofonlinebankingandretailelectronic paymentsinthe2000s.Whiletheseinnovationshavebeenshiftingthebalanceinthefinancial systemfrombankstowardsmarketsandspecializedplayers,theoverallstructureofthefinancial industrywithbanksatitscoreremainedremarkablyrobust(Philippon2015). 1 Inthispaper,we 1 Overtwentyfiveyearsago,BoydandGertler(1994)asked“AreBanksDead?OrAretheReportsGreatly Exaggerated?”andconcludedthattheroleofbankshadinfactnotdiminished.Bankswereneitherdrivento irrelevancebythedisruptioncausedbytheGlobalFinancialCrisis. ECB Working Paper Series No 2438 / July 2020 8arguethattheongoingchangesaremo