Will video kill the radio star? Digitalisation and the future of banking

Reports of the Advisory Scientific Committee

No 12 / January 2022

Will video kill the radio star? - Digitalisation and the future of banking

by

Thorsten Beck, Stephen Cecchetti, Magdalena Grothe, Malcolm Kemp, Loriana Pelizzon, Antonio Sánchez Serrano

Contents

Executive summary	2
1	Introduction	6
2	Digitalisation as a challenge for banks' business model	12
	2.1	Financial innovation - is this time different?	12
	2.2	Incumbent banks' new competitors: fintech and big tech	16
	Box 1	Lending platforms	20
	2.3	The funding of fintechs and big techs vs banks	24
	2.4	The reaction of incumbent banks to their new competitors	26
3	Emergence of new risks and reshaping of existing risks	30
	3.1	Financial risks from new providers	30
	3.2	Non-financial risks	33
4	Three scenarios for the financial system in 2030	37

4.1 Starting point: the EU banking system before the COVID-19

		pandemic	37
	4.2	Scenario 1: incumbent banks continue their dominance	40
	4.3	Scenario 2: incumbent banks retrench	41
	4.4	Scenario 3: central bank digital currencies	42
5	An EU macroprudential policy response	44
References		47

Annex: The EU banking system compared with the US and Japanese banking

systems	54
Imprint and acknowlegements	63

Reports of the Advisory Scientific Committee No 12 / January 2022

Contents

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Executive summary

Taking into account the many forces currently affecting the EU banking system, this report considers how digitalisation may change the way financial services are provided in the future, identifying financial and non-financial risks and forming possible policy responses to them.

The European banking system is confronting fundamental structural changes and challenges that are going to shape its future and ability to serve the financial needs of the real economy. Some, such as overbanking and the legacy of non-performing loans (NPLs), have been present for several years and can be seen as legacy problems dating back to the global financial and European sovereign debt crises. Against a background of a bank-centric financial system, the EU banking system has experienced contained growth and strong deleveraging since the global and sovereign debt crises. In parallel, the non-bank financial sector has materially increased its assets under management, often intensifying activities typically associated with banks.1 Other challenges, such as digitalisation and climate change, are forward-looking in nature and relate to societal changes beyond the banking and financial systems. On top of that, the COVID-19 pandemic may be affecting economic structures, exerting an impact on the banking system that may touch the core business models and operations of European banks.

Financial innovation has been a defining feature of the financial sector over the centuries, in the shape of new products (e.g. new types of securities), new technologies (e.g. credit scoring, automated teller machines (ATMs)) and new institutions (e.g. venture capitalists, mutual funds). While financial innovation poses regulatory challenges and might create new sources of systemic risk, it has the potential to result in cheaper and more convenient services, more efficient and less costly delivery and greater competition and contestability in the financial system. The current wave of financial innovation is being supported by specific technological advances, involving: (i) smart phone technology, the internet and application programming interfaces (APIs); (ii) artificial intelligence (AI) and big data technology; and (iii) distributed ledger technology (DLT).

The recent wave of financial innovation, though no different from past waves, has come mostly from outside the incumbent banking system in the form of new financial service providers, either in competition or cooperation with incumbent banks but with the potential for substantial disruption. Across the globe, fintechs have shown impressive growth and are typically small and specialised in specific services (although, in aggregate, they cover a large diversity of financial services). Big techs, usually operating through platforms, derive advantages from data analytics, network externalities and interwoven activities, and follow an envelopment strategy moving from non- financial into financial services.

As a result, 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 big techs, however, incumbent banks could react in different ways, depending on

1 The development of the non-bank financial sector can be beneficial from a macroprudential point of view, as it can increase risk sharing across the financial system. It can also have detrimental effects on financial stability, because financial risks, including liquidity risks, that are inherent to the provision of financial intermediation services by banks could shift to areas of the financial system that are not typically as highly regulated as the banking sector.

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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.

In this process, new risks may emerge and existing risks may be reshaped. 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 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 contribution of financial and non-financial risks to the overall level of risk in the system depends on (i) the current state of the EU banking system (which, in the aggregate and compared with banking sectors in other major advanced economies, cannot be characterised as strong)2 and (ii) how incumbent banks interact with fintechs and big techs in the future, an area still dominated by uncertainty. Consequently, this report uses three alternative scenarios for the EU financial system in 2030 as a basis for discussing the appropriate macroprudential policy responses:

1. In scenario 1, incumbent banks continue to dominate and maintain their central role in money creation and financial intermediation. They aggressively counter the competitive threat through technological adaptation, acquiring fintech companies and lobbying. Fintechs continue to focus on specific niche markets, while big techs offer payment services but do not have access to central bank clearance and payment systems (they might cooperate with incumbent banks). The banking system renews itself by incorporating new providers and new products.
2. In scenario 2, incumbent banks retrench, while big techs offer financial services through regulated subsidiaries and capture the hard data, transaction-based lending market. Incumbent banks increasingly focus on relationship-intensive services, at both the high end (investment banks) and low end (community banks) of the market. The banking system shrinks, especially

2 The EU banking system currently has a predominant position in funding the real economy, with a relatively strong presence of legacy assets from the previous crisis and a structurally low level of profitability. The Annex provides a more detailed description of the EU banking system, including a comparison with banking systems in the United States and Japan.

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because mid- and small-sized banks are no longer able to exploit scope economies. This scenario leads to a structural change in the financial system.

3. In scenario 3, issuance of retail central bank digital currencies, under certain intermediation models, leads to a very different structure of the financial system. Incumbent banks face higher funding costs and a more volatile funding base, as the traditionally stable retail deposit clientele might switch to the digital currency. Financial intermediation moves away from incumbent banks, while the central bank plays an increasing role as an intermediary. Other financial service providers (including fintechs and big techs) offer tailormade and specialised services in lending, asset management and risk management. The traditional banking system would no longer play the role of a stable anchor.

Given that developments in financial system are endogenous to regulatory responses and adjustments, especially during potentially disruptive transformations, this report proposes several policy actions to address financial and non-financial risks. Some of these actions would apply to all three scenarios, while others would be more relevant if only one of the three scenarios materialises. Critically, the regulatory response will be a key driver of which of the three scenarios materialises.

These policy actions can be grouped as follows:

• The first covers the issue of the definition and possible expansion or adaptation of the regulatory perimeter, and of the conditions for accessing the safety net. If performing bank-like financial activities, fintechs and big techs should have access to the safety net. In parallel, a prudential framework should be developed, also including consumer protection and anti- money laundering. This becomes more important in the scenarios of bank retrenchment and central bank digital currencies.
• Global cooperation may need to be enhanced here, since most fintech and big tech companies may operate on a global scale with no permanent establishment in most jurisdictions where they are present. To avoid undesired and untimely discussions, mechanisms for cooperation should be put in place ex ante.
• 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. This policy may require profound organisational changes in big techs and substantially reduce the appeal of entering the financial intermediation business, greatly decreasing the probability of the second scenario (banks' retrenchment).
• 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. Such cooperation might also be required across borders, given the global nature of most big techs. As the regulatory and legislative approaches towards platform companies (i.e. big techs) change at EU level, such changes should involve close cooperation with financial sector regulators.
• 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. Digitalisation may increase the

Reports of the Advisory Scientific Committee No 12 / January 2022

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