Digital Disruption in Banking and its Impact on Competition 1 DIGITAL DISRUPTION IN BANKING AND ITS IMPACT ON COMPETITION OECD 2020 Digital Disruption in Banking and its Impact on Competition PUBE2 | DIGITAL DISRUPTION IN BANKING AND ITS IMPACT ON COMPETITION OECD 2020 This work is published under the responsibility of the Secretary-General of the OECD. The opinions expressed and arguments employed herein do not necessarily reflect the official views of the OECD or of the governments of its member countries or those of the European Union. This document and any map included herein are without prejudice to the status or sovereignty over any territory, to the delimitation of international frontiers and boundaries and to the name of any territory, city, or area. OECD 2020 Please cite this publication as: OECD (2020), Digital Disruption in Banking and its Impact on Competition oecd/daf/competition/digital-disruption-in-financial-markets.htm 3 DIGITAL DISRUPTION IN BANKING AND ITS IMPACT ON COMPETITION OECD 2020 Foreword This paper, by Professor Xavier Vives (IESE Business School) surveys technological disruption in banking, examining its impact on competition and its potential to increase efficiency and customer welfare. It analyzes the possible strategies of the players involvedincumbents and FinTech and BigTech firmsand the role of regulation. The industry is facing radical transformation and restructuring, as well as a move toward a customer-centric platform-based model. Competition will increase as new players enter the industry, but the long-term impact is more open. Regulation will decisively influence to what extent BigTech will enter the industry and who the dominant players will be. The challenge for regulators will be to keep a level playing field that strikes the right balance between fostering innovation and preserving financial stability. Consumer protection concerns rise to the forefront. This is a revised version of the paper prepared for an OECD Competition Committee roundtable held on 5 June 2019. The author is grateful to Ania Thiemann for very detailed comments, to Patrick Bolton, Antonio Capobianco, and Stijn Claessens for useful suggestions that improved the paper, and to Giorgia Trupia and Orestis Vravosinos for excellent research assistance. 5 DIGITAL DISRUPTION IN BANKING AND ITS IMPACT ON COMPETITION OECD 2020 Table of Contents Foreword . 3 Chapter 1. Introduction . 7 Chapter 2. Technological Disruption and Efficiency . 9 2.1. Supply and Demand Drivers of Digital Disruption . 9 2.2. FinTech and Efficiency . 12 Chapter 3. New Entrants and Incumbents: Competition or Co-operation? . 19 3.1. Player Strategies: Incumbents and FinTech firms . 21 3.2. Player Strategies: Incumbents and BigTech Platforms . 21 3.3. Summary . 24 Chapter 4. Competition and the Role of Regulation . 27 Chapter 5. Financial Stability Implications of Digital Disruption . 33 Chapter 6. Summary and Conclusion . 37 Chapter 7. Some Open Issues . 41 References . 43 Tables Table 1. FinTech firms advantages and disadvantages . 15 Table 2. Strategies: incumbents and FinTech firms . 21 Table 3. Strategies: incumbents and BigTech firms . 23 Figures Figure 1. A world where a BigTech platform controls the interface of the customers in its ecosystem and where banks compete to supply products and services through this platform. . 23 Boxes Box 1. Digital Currencies . 10 Box 2. Fintech Innovations: P2P Lending and Robo-Advising. 11 Box 3. The case of China . 14 Box 4. Competition Bureau Canadas Assessment of Fintech . 30 7 DIGITAL DISRUPTION IN BANKING AND ITS IMPACT ON COMPETITION OECD 2020 Chapter 1. Introduction Since the 20072009 financial crisis, the banking industry has been faced with low interest rates, deleveraging and/or low credit growth, increased regulation and compliance requirements, and a damaged reputation. Along with the appearance of these threats, major changes have taken place in the banking sector in recent years. A decade ago, the ten largest banks by assets were based in Europe or the United States, whereas currently the top ten are dominated by six Asia-based banks. The reason for this shift can be traced not only to the crisis and the rise of Asia; banks have had to deal with all the threats arising after the crisis, as well as digital disruption stemming from increased competition in retail from financial technology (FinTech) and platform-based competitors. The profitability of the sector has been threatened, with European and Japanese banks barely covering their cost of capital. A legitimate question is what the top ten list will look like in a decade. I note that the capitalization of large technological companies such as Amazon or Google is more than double that of JP Morgan Chase. Banking is undergoing a transformation from being based in physical branches to using information technology (IT) and big data, together with highly specialised human capital. Even before this transformation began, banks and markets had become intertwined, with a higher proportion of intermediary activities becoming market based. Banks face greater competition from other intermediaries, increasingly digital, in their core businesses, such as payment and advisory services. A change in the use of technology in developing new services and business models has been unfolding with the rise of the FinTech sector, which can be understood as the use of innovative information and automation technology in financial services. The speed of adoption of the different new digital technologies and of the acquisition of users associated to them has accelerated markedly. Indeed, the major change is now coming from digital disruption of the sector, which is leaving incumbents with potentially obsolete legacy technologies (e.g. mainframes) and overextended branch networks to serve the standards of service that new competitors can provide. Customers have new service expectations in terms of user-friendliness of the interface and transparency. In Asia and Africa, technological leapfrogging has extended banking services to previously unbanked segments of the population. Digital technology may have a large impact in terms of increasing competition and contestability of banking markets. Banking will move toward a customer-centric platform- based model, and incumbents will have to restructure. 1 This digital disruption offers the potential to improve efficiency with innovation, enhanced supply diversity, and a more competitive financial system that yields market extension augmenting financial inclusion. This disruption will put pressure on the margins of incumbents, perhaps leading to increased risk taking, and will start a competition to capture the rents in the sector. In order to achieve improved efficiency, the incumbents must restructure simultaneously with the entry of the new competitors, and new dominant positions should not become entrenched. The new entrants, FinTech and especially BigTech (i.e., large technology companies that expand toward the direct provision of8 | DIGITAL DISRUPTION IN BANKING AND ITS IMPACT ON COMPETITION OECD 2020 financial services or products), 2 should gain market share because of efficiency gains rather than by bypassing regulation or monopolizing the interface with customers. Furthermore, regulators must strive to detect new threats to financial stability from the new forms of systemic risk derived. The remainder of this review is organised as follows. Chapter 2. describes the technological disruption to the banking/financial sector. Chapter 3. deals with the interaction between the new entrants and incumbents. Chapter 4. considers the impact of regulation, and 0focuses on financial stability implications. Chapter 6. presents conclusions, and Chapter 7. addresses open research issues. Notes 1 Traditionally, banks have focused on the provision of products, while digital companies have moved the business model toward a more holistic approach that aims to solve clients problems and set up new standards of service and customer experience. According to Investopedia, customer- centric “is an approach to doing business that focuses on creating a positive experience for the customer by maximizing service and/or product offerings and building relationships” ( see Vives 2016, 2019 for an overview of competition in banking, with attention to recent developments). 2 Typically, BigTech firms are platform based (e.g. Amazon, Google, Apple). 9 DIGITAL DISRUPTION IN BANKING AND ITS IMPACT ON COMPETITION OECD 2020 Chapter 2. Technological Disruption and Efficiency Banks perform several important functions in the economy. The core one consists of maturity transformation and liquidity provision: taking deposits short term and making loans long term. This function is accompanied by the monitoring of opaque loans that would have trouble being funded by the market. A second function consists of payment and transaction services. Both functions rely on information processing of both hard information, verifiable and codifiable, and soft information, based on relationship banking. The digital revolution has greatly increased the weight of codifiable information and the tools that are available to process it, artificial intelligence (AI) and machine learning (ML) using mainly big data. Therefore, the functions that are more exposed to information processing, such as payment and transaction services, will be more affected (see Vives 2016, sect. 3.1, for an overview of banks functions). This section addresses first the supply and demand drivers of digital disruption followed by the impact of FinTech on efficiency. 2.1. Supply and Demand Drivers of Digital Disruption 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 (Carstens 2018, FSB 2019). On the technological supply side, relevant factors are internet application programming interfaces (APIs), 1 cloud computing, smartphones, digital currencies, and blockchain technology. APIs have enabled service improvements, especially faster payments, and have provided support for easier unbundling of services. They have become the standard for data sharing in so-called open banking applications. 2 Such applications allow third-party access to consumers bank data (with the consumers consent) and are becoming a fundamental tool of digital disruption. They 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 (e.g. OECD 2018). Cloud computing refers to the practice of using a network of remote servers, typically accessed over the internet, for the provision of IT services and for the storage and sharing of data. It has the advantage of flexibility in delivering services and cost-effectiveness. It 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. In this respect, the EU, the United Kingdom, Singapore, Japan, and Hong Kong, China have been developing frameworks for the application of APIs. Mobile devices have become indispensable in consumers daily lives, expanded the availability of financial services, and become a platform for third-party developers. They 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. Their integration is highly advanced in Asia, where payment10 | DIGITAL DISRUPTION IN BANKING AND ITS IMPACT ON COMPETITION OECD 2020 apps are currently serving a billion users and are part of a bundle with e-commerce, chat, deliveries, food ordering, and ride hailing. 3 Even though the traditional or high street banks Visa and MasterCard are still the leaders of the market for transaction payments, nonbanks such as PayPal, Apple, and Google and new entrants such as Revolut, N26, and TransferWise are often behind payment innovations. For example, mobile-based payment schemes have a considerable effect in jurisdictions where the share of the population owning a current account is low. This is often the case in African countries, where only one-quarter of the population has a bank account but many more people have access to a mobile phone (The Economist 2015). 4 New payment systems as well as loans targeted to consumers with short credit history are often tested in such geographical areas, which represents technological leapfrogging for people who do not have a bank account but have access to banking services through their mobile phones. Traditional payment systems and banking may also be disrupted by digital currencies. Cash is being used less and less. 5 The traditional functions of money are as a medium of exchange, as a store of value, and as a unit of account. Many examples of digital currencies already exist, such as Alipay and WeChat Pay in China, M-Pesa in Kenya, the Libra project sponsored by Facebook, and cryptocurrencies and stablecoins. 6 There is no consensus on the definition of e-money, but basically it is akin to bank money (e.g. deposit or debit card) but, in principle, without the guarantee of the government 7 (see Box 1). Box 1. Digital Currencies Different means of payment can be classified as objects, such as cash, central bank digital currency, cryptocurrencies including bitcoin or other digital coins, or claims such as money issued by banks or other intermediaries (Alipay, WeChat Pay, M-Pesa, or blockchain-based monies such as Paxos or USD Coin) (Adrian this is particularly true in Europe, where assets under robo-management amount to much less than those in the United States. 2.2. FinTech and Efficiency The use of new technology has important implications for the welfare of market participants that may lead to lower financial intermediation costs in lending, payment systems, financial advising, and insurance, along with better products for consumers (see Philippon 2018, who emphasises that the unit cost of financial intermediation has not gone down until relatively recently despite technological progress, as well as Vives 2017). Through online origination technology, FinTech firms offer more convenience to their borrowers. FinTech drives efficiency in several ways: 1. It can more effectively screen candidate borrowers via statistical models based on big data, thereby overcoming the information asymmetries that are at the root of the banking business. Importantly, information may be a substitute for collateral; therefore, FinTech-based entities