Implications of FinTech developments for banks
The Basel Committee on Banking Supervision (BCBS) published a report recently assessing how FinTech may affect the banking industry and the activities of supervisors in the near to medium term. The report has been produced as a result of the increased focus on FinTech.
The BCBS argues that banks will have difficulty in maintaining their current operating models, given technological change and customer expectations. The report identifies the "customer relationship" as a key battleground between incumbents and new entrants and argues that this will vary depending on each scenario. We agree with these arguments and are working with a number of incumbent banks and new entrants that are digitising their existing businesses or moving onto entirely new "rails".
The report also considers five future potential scenarios:
| Better Bank | Incumbent banks digitising and modernising to maintain customer relationships |
| New Bank | Digital first, start-up banks |
| Distributed Bank | Modularised banking system where banks and FinTech firms collaborate and compete |
| Relegated Bank | Banks become commoditised service providers |
| Disintermediated | Banks become even less relevant! (Although BCBS notes this is unlikely) |
We think the future of banking services is likely to be a mix of the first three, and we are already seeing this play out in the industry. But those banks and other financial services firms who have yet to truly digitise their businesses may see themselves become a "Relegated Bank" to the rest of the industry.
BCBS taskforce
At this stage, the BCBS is keen to stimulate a discussion and describe what it views as the risks and opportunities posed by FinTech, as opposed to setting out concrete requirements or recommendations.
For the report, the BCBS set up a taskforce to analyse financial technology innovations and emerging business models in the banking sector. The BCBS uses the Financial Stability Board's definition for FinTech as “technologically enabled financial innovation that could result in new business models, applications, processes, or products with an associated material effect on financial markets and institutions and the provision of financial services”. The BCBS notes that there is lack of a common definition of FinTech, innovation or other similar terms among surveyed agencies. It states that some definitions it had encountered made a clear distinction between innovation and disruption, with existing regulatory frameworks able to address innovation, while "disruption "requires new rules.
As part of the taskforce's exercise, the BCBS set out current FinTech landscape and supervisory approaches to FinTech developments, using industry research and surveys of member institutions. It then identified the implications for banks and challenges for effective supervision. The report considers five future potential scenarios summarised above: the better bank, the new bank, the distributed bank, the relegated bank, and the disintermediated bank. The report also contains six case studies focussing on specific innovations. Three of the case studies consider enabling technologies (Big Data, distributed ledger technology (DLT) and cloud computing), while three consider FinTech business models (innovative payment services, lending platforms, and neo-banks).
Scenarios
Better bank
In this scenario, the incumbent banks digitise and modernise themselves so as to retain the customer relationship and core banking services, leveraging enabling technologies to change their current business models. The key risks under the better bank scenario focus on the execution risk related to the implementation of the new strategy (banks’ ability to manage and effectively implement both the technology and business process changes) and the strategic and profitability risks.
New bank
In this scenario, incumbents cannot survive the onslaught of new technology-driven banks such as neo banks/banks set up by big-tech companies with full-service "built-for-digital" banking platforms. These banks apply advanced technology to provide services in a more cost-effective and innovative manner. The report cites Varo Money in the US and Fidor in Germany and UK as examples but says the new bank model is not currently a predominant model. The size and scale of many incumbent banks may make it difficult to effectively modernise and digitise their current processes to achieve cost-effective operations as well as to provide innovative products for customers within an acceptable timeframe.
Distributed bank
In this scenario, financial services are "modularised" but incumbents can still survive and there is a fragmentation of financial services among specialised FinTech firms and incumbent banks. Banks and FinTech companies operate as joint ventures, partners or use other structures involving shared delivery of services. BCBS cites the use of open APIs as an example of this, as well as robo-advisor or automated investment advisory services. The key risks highlighted in most of the case studies for the distributed bank scenario focus on banks’ and bank supervisors’ ability to monitor and manage end-to-end transactions across one or multiple third parties.
Relegated bank scenario
In this scenario, incumbent banks become commoditised service providers while other financial service providers such as FinTech and BigTech companies take over the direct customer relationship. FinTech and BigTech companies use front-end customer platforms to offer financial services, while big data, cloud computing and artificial intelligence are employed by front-end platforms making use of connectivity and data to improve the computer experience. The BCBS states that in this scenario, there is a risk that banks and bank supervisors will have limited ability to monitor end-to-end transactions and systemic risk. The loss of customer relationship can also impact risk management function and undermine consumer protection.
Disintermediated bank
This scenario sees a heavily reduced profile for incumbent banks as the need for balance sheet intermediation or for a trusted third party is removed. Banks are displaced from customer financial transactions by more agile platforms and technologies. The BCBS notes that the disintermediated bank scenario is considered unlikely to gain significant scale in the short to medium term. However, the key risk identified in this area would be less secure financial activities.
Fintech – implications and considerations
The BCBS has identified 10 key implications and related considerations for banks and bank supervisors. These look at the key risks and opportunities; implications of using innovative enabling technologies; outsourcing and partnering risk; impact on bank supervisors and regulatory frameworks, including the increased need for cooperation and the impact on supervisors' internal organisation; and facilitation of innovation.
| Implication | Consideration |
|---|---|
| Implication 1: The nature and scope of banking risks as traditionally understood may significantly change over time with the growing adoption of FinTech, in the form of new technologies that can affect bank business models. While these developments may give rise to new and additional risks, they may also open up new opportunities for consumers and banks. | Consideration 1: While bank supervisors must remain focused on ensuring the safety and soundness of the banking system, they should be vigilant for opportunities to enhance both safety and soundness and financial stability, while monitoring for current practices that might unduly or unintentionally hamper beneficial innovations in the financial industry. |
| Implication 2: Key risks associated with the emergence of FinTech include strategic risk, operational risk, cyber-risk and compliance risk. These risks pertain to both incumbent banks and new FinTech entrants. | Consideration 2: Safety and soundness and financial stability can be enhanced by implementation of supervisory programmes to ensure that banks have effective governance structures and risk management processes that appropriately identify, manage and monitor risks arising from the use of FinTech, including associated new business models applications, processes or products. |
| Implication 3: Banks, service providers and other FinTech firms are increasingly adopting and leveraging advanced technologies to deliver innovative financial products and services, such as artificial intelligence, machine learning, advanced data analytics, distributed ledger technology, cloud computing and application programming interfaces. These developments present risks as well as opportunities. | Consideration 3: Banks relying on these innovative technologies should ensure they have effective IT and other risk management processes and control environments that effectively address new sources of risk. Bank supervisors could enhance safety and soundness by ensuring that banks adopt such risk management processes and control environments. |
| Implication 4: Banks are increasingly relying on third-party service providers for operational support of technology-based financial services; as a result, the delivery of these services has become more modular and commoditised. The primary drivers of outsourcing are cost reduction, operational flexibility and increased security and operational resilience. While operations can be outsourced, the risks and liabilities associated with those operations remain with the banks. | Consideration 4: Safety and soundness and financial stability can be enhanced by implementation of supervisory programmes to ensure that banks have appropriate risk management practices and processes over any operation outsourced to or supported by a third party, including FinTech firms, and that controls over outsourced services are maintained to the same standard as those applied to operations that the bank itself conducts. Relevant practices and processes include due diligence, operational risk management, ongoing monitoring and appropriate execution of contracts with third-party service providers that set out the responsibilities of each party, agreed service levels and audit rights. |
| Implication 5: FinTech developments are expected to raise issues that go beyond the scope of prudential supervision, as other public policy objectives may also be at stake, such as safeguarding data privacy, cybersecurity, consumer protection, fostering competition and compliance with AML/CTF. | Consideration 5: Where appropriate, safety and soundness and financial stability can be enhanced by bank supervisors communicating and coordinating with relevant regulators and public authorities, such as those charged with data protection, consumer protection, fair competition and national security, to ensure that banks using innovative technologies are complying with the relevant laws and regulations. |
| Implication 6: Many FinTech firms, in particular those focused on lending and investing activities, currently operate at the regional or national level. However, some FinTech firms, especially those engaged in payments (in particular, wholesale payments) and cross-border remittances, already operate in multiple jurisdictions and have high potential to expand their cross-border operations. | Consideration 6: Given the current and potential global growth of FinTech firms, global safety and soundness can be enhanced by further supervisory coordination and information-sharing where appropriate for cross-border FinTech that affects banks. |
| Implication 7: FinTech has the potential to change traditional banking business models, structures and operations, including the delivery of financial services. Such FinTech-related changes may require bank supervisors to reassess their current supervisory models and resources in order to ensure continued effective oversight of the banking system. | Consideration 7: Safety and soundness could be enhanced by bank supervisors assessing their current staffing and training programmes to ensure that the knowledge, skills and tools of their staff remain relevant and effective in supervising the risks of new technologies and innovative business models. Supervisors may need to consider the addition of staff with specialised skills to complement existing expertise. |
| Implication 8: The same technologies that offer efficiencies and opportunities for FinTech firms and banks, such as AI/ML/advanced data analytics, DLT, cloud computing and APIs, may also have the potential to improve supervisory efficiency and effectiveness. | Consideration 8: Safety and soundness and financial stability could be enhanced by supervisors investigating and exploring the potential of new technologies to improve their methods and processes, and they may wish to share with each other their practices and experiences. |
| Implication 9: Current bank regulatory, supervisory and licensing frameworks generally predate the emergence of technology-enabled innovation. In some jurisdictions, prudential authorities do not have a remit for firms that are not banks, and some services previously conducted by banks are now being provided by other firms that may not be regulated by bank supervisors | Consideration 9: Where appropriate, a review by bank supervisors of their current supervisory frameworks in the light of new and evolving FinTech risks could uncover ways in which elements of these frameworks could evolve in a manner that ensures appropriate oversight of banking activities while not unduly or unintentionally hampering beneficial innovation. |
| Implication 10: Supervisors in some jurisdictions have put in place initiatives to improve interaction with innovative financial players that could facilitate innovative technologies and business models for financial services, for example innovation hubs, accelerators and regulatory sandboxes. | Consideration 10: Supervisors could learn from each other’s approaches and practices, and consider whether it would be appropriate to implement similar approaches or practices. Implications and considerations can be used as a basis for determining follow-up actions individual supervisors may wish to consider, as well as future BCBS monitoring of risks associated with emerging technologies and innovative business models. |
The BCBS states that it will continue to monitor FinTech developments and assess whether and how these implications and considerations should be updated as appropriate. Supervisors are invited to use the implications and considerations as a basis for determining follow-up actions.
FinTech has the potential to transform the provision of financial services; the introduction of Open Banking and other initiatives are a key example of this. Although the BCBS report is the latest in the long line of research papers on FinTech, it provides an engaging insight into the changing dynamics and relationships between players in financial services, and is a timely reminder of the need for a dynamic and informed approach by supervisors. Existing players or incumbents will no doubt heed the warning in relation to digitising their businesses in the face of new entrants in order to become a "better bank" rather than a "relegated bank".
Terms used in the report
- BigTech. This refers to large globally active technology firms with a relative advantage in digital technology. These firms usually provide web services (search engines, social networks, e-commerce etc) to end users over the internet and/or IT platforms or they maintain infrastructure (data storage and processing capabilities) on which other companies can provide products or services. Examples of BigTech firms in the western world are Google, Amazon, Facebook and Apple, collectively known as GAFA.
- Big data. The large volume of data that can be generated, analysed and increasingly used by digital tools and information systems. This capability is driven by the increased availability of structured data, the ability to process unstructured data, increased data storage capabilities and advances in computing power.
- Neobanks. These banks make extensive use of technology in order to offer retail banking services predominantly through a smartphone app and internet-based platform. They leverage scalable infrastructure through cloud providers or API-based systems to better interact through online, mobile and social media-based platform.
- Accelerators. Projects or programmes by supervisors or central banks where private sector firms are involved to address specific problems or to explore new technologies.
- Innovation accelerator. This is a partnership arrangement between FinTech providers and central banks/supervisory agencies to develop use cases that may involve funding support and/or authorities’ endorsement/approval for future use in central banking operations or in the conduct of supervisory tasks.
- Machine learning. Method of designing problem-solving rules that improve automatically through experience
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