Financial innovation tends to be disruptive; while bringing many benefits for consumers, it can also bring new sources of fragility, both related to new products and providers and to the retrenchment of incumbent providers.
I have written on both aspects before, both on the growth and fragility effects of financial innovation as on one specific innovation. With several colleagues at the Advisory Scientific Committee and the Secretariat of the ESRB I have been working on a report that gauge the possible impact of digitalisation and the financial innovations it has brought with it on banking in Europe.
entry of new providers, incumbent banks face competition across different business lines, and disintermediation may result in losses of scale and/or scope economies. Banks typically expect fintechs not to threaten their incumbency, albeit with some need to
buy out innovators to sustain this position. With bigtechs, however, incumbent banks could react in different ways, depending on how big techs go about expanding into financial service provision: by establishing subsidiaries or cooperating with incumbent banks.
The former approach would constitute a direct challenge for incumbent banks, which might react by increasing their risk profile to defend their position. Cooperation seems less disruptive, although it would also likely erode the rents that incumbent banks
have enjoyed until recently, potentially rendering many of them unviable in their current business model.
New providers entering with bank-like intermediation
models would be exposed to the known risks in banking (liquidity risk, credit risk, market risk, etc.), affecting, in turn, system-wide risk. While more competition could enhance stability over the long term, concentration (particularly with big techs) could
result in new too-big-to-fail institutions, and a stronger focus on transaction-based intermediation could make the system more procyclical. Furthermore, incumbent banks may take greater risks to compete with new providers. Cooperation between big techs and
incumbent banks might lengthen intermediation chains, moving them towards the originate-and-distribute model, which raises concerns about incentives and risk distribution.
In addition to financial risk, digitalisation also poses significant non-financial risks, both for banks and for fintech and big tech companies. These risks stem from (i) greater concentration on providing basic services, such as cloud computing; (ii)
broader use of artificial intelligence (AI) in finance; (iii) overly automated or IT-oriented services that may be more prone to cyberattacks; (iv) trust in a leading technology that might suddenly turn obsolete; and (v) a false sense of security from overleveraging
insights from AI.
The report then presents three scenarios for the EU banking system in 2030 as a basis for discussing the appropriate macroprudential policy responses:
(i) incumbent banks continue to dominate and maintain their central role in money creation and financial intermediation, (ii) incumbent banks retrench, while bigtechs offer financial services through regulated subsidiaries and capture the hard data, transaction-based
lending market, (iii) the issuance of retail central bank digital currencies can lead to a very different structure of the financial system, with incumbent banks facing higher funding costs and a more volatile funding base, as the traditionally stable retail
deposit clientele might switch to the digital currency.
The analysis and three scenarios give risk to a number of macroprudential policy recommendations:
- The regulatory perimeter and the conditions for accessing the safety net have to be possibly expanded or adapted
cooperation may need to be enhanced further, since most fintech and big tech companies operate on a global scale
- The financial intermediation activities of big techs may need to be ring-fenced and therefore provided
through a subsidiary that falls within the regulatory perimeter
- The extended use of non-financial providers of services, which may fall under a different regulatory authority (e.g. telecom regulator), may require
enhanced cooperation between regulators in different sectors and jurisdictions
- Increased digitalisation in financial services may require a change in regulatory and supervisory practices, which were defined when
digitalisation was in its infancy and non-financial risks were not high on the regulatory agenda
- Political decisions on the issuance of central bank digital currencies to retail customers have to carefully balance
efficiency gains with any stability risks this poses to the incumbent financial system
- The support framework for an orderly exit and capacity reduction of incumbent banks should be strengthened
Here is the Vox column that summarises the main messages.