Fintech: Wiping Out the Banks, or Overrated?

Leiden, prid. Kal. Sep. MMDCCLXVIII A.U.C.,

In the aftermath of the financial crisis a new financial term has come in vogue: Fintech. It is an acronym for financial technology, and it can refer to any technological innovation in the financial sector. More recently, however, it has been more and more related to a variety of start ups in the financial sector, which aim to revolutionize the traditional banking world (Definition of fintech). These new companies bring people together who either have too much, too little, or the wrong money, using the internet. In other words, debitors, creditors, investors, entrepreneurs and those who want to exchange different currencies nowadays can find platforms which circumvent the traditional financial sector. These platforms are much cheaper, in part because they are much more elegant than conventional financial institutions, in part because they have to comply with less regulation in some countries.

This has certainly drawn the attention of governments in several places, such as the UK, the Netherlands, often as a positive development that needs to be welcomes and needs government support. To some degree this makes sense. The key to all these fintech companies is liquidity, they need sufficient supply and demand to make sure that people can use their platforms to exchange money. While traditional banks do this to some degree as well, they can also use the international financial markets to obtain money, if they need to. However, the key to profits for fintech companies is that they form a self-contained market, because only transactions which use their platform are profitable to a fintech company. Seeing liquidity is of utmost importance, and liquidity is achieved through having a lot of customers, the terms that come to my mind are 1. network effects and 2. advantages of scale. The former term means that fintech companies function like a network, and the bigger the network, the better the network. The latter term means more or less the same, it implies that the bigger the scale of the fintech company, the lower the costs of better services. In this sense fintech companies are no different from many other modern technological start-ups, like Facebook, AirBNB or Uber.

Whenever network effects and advantages of scale are at work, it becomes important for countries to be the first to get in on a new technology, because those that attain large size first have an ‘incumbency advantage’. Or, in other words, those first big fish can eat all the newer little fish. Once a network is established, and a company has attained advantages of scale, it is very difficult for a new company to take over the established network, while in the first few years this is costly, because the new company is much smaller, and thus has relatively high costs. Consequently, countries want to be among the first to host the newest fintech giants, because once they are settled, it might prove to be incredibly difficult to compete with those giants. Hosting fintech companies can be a lucrative business, amongst other things they will pay taxes, they might employ citizens, and they provide liquidity. Therefore we can expect a race to the bottom between governments in terms of the regulation of fintech companies. Many of them will want to attract fintech companies, in order to use the incumbency advantage, and one of the ways they can do so, is by making it easy to start up and run such a company, because of little regulation.

However, I think some words of caution are due. Firstly, we can expect banks to lobby in favour of regulation of the fintech companies, because they represent a direct threat to traditional banking. We have to make sure that the traditional banking sector does not prevent fintech from becoming the next big thing, purely because fintech is dangerous to banks. Secondly, we nevertheless might have good reason to regulate fintech, just like we regulate traditional banks. My intuition says that fintech can be less risky than banks, because fintech companies right now do not tend to provide a whole range of financial services. Therefore, a downturn in one financial market, does not have to spill over into other financial markets (exactly like what happened in 2008, when the mortgages market soured, and the complete financial system crashed, because so many banks were directly or indirectly tied up in mortgages). So less regulation for fintech companies than for banks might be in order, but do we know that already? Should we simply go by gut feeling, or should we first figure out what fintech companies do to a financial system, and until that time let them be subject to the same regulation as banks? Admittedly, this would be an advantage to banks, they are older, and thus have more experience with financial regulation, making it less of a burden to them. On the other hand, the only way to find out if fintech companies really are more efficient than conventional financial institutions, is by letting them compete on a level playing field.

Thirdly, given the EU is one market, should we allow these start ups to force governments into a race to the bottom, or should we use the EU to make sure that governments implement the same regulation (which definitely has its own disadvantages)? Fourthly, especially in the Netherlands and the UK, shadow banking (Definition of Shadow Banking, in short it refers to financial institutions that are not banks, but perform a similar role to banks) already is quite big (For the Dutch case see De Schaduwelite, Ewald Engelen). At least in the Netherlands, the shadow banking sector is comprised of financial institutions that are technically and legally not, yet in practice very often are banks, which allows banks to legally dodge regulation. Of course it is great if small fintech companies manage to provide more liquidity at lower costs, because they require less regulation, which would people to circumvent traditional banks, but given the existence of shadow banking, the lack of regulation might simply allow banks to use fintech to set up large unmonitored financial vehicles, that are still the burden of the taxpayer to save if (or should I say when) they crash.

All in all fintech offers us quite some tantalizing prospects, and there is real cause to be excited about it. However, we should firstly make sure that banks do not somehow stifle these developments. Secondly, we need to ensure that fintech companies out compete banks, because they are better at what they do, rather than because of regulatory competitive advantages. Thirdly, we need to make sure that we think about how we want to regulate fintech companies, rather than participating in a race to the bottom simply because we want to attract fintech companies as soon as possible, without thinking about pros and cons of fintech. Lastly we should prevent banks from using a lack of regulation of fintech to use the shadow banking system to avoid regulation of their normal practices.


Bottom Line: There are financial new kids on the block, who can potentially provide us with a lot of sweet, sweet candy, at prices which we can afford with our pocket money. On the other hand, we probably should make sure to brush our teeth, if we want to make sure that we will not get some financial caveats.

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5 thoughts on “Fintech: Wiping Out the Banks, or Overrated?

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  1. I think you need to define the market for Fintech more carefully. Banks, after all, can mean savings/lending or investment banks. Given a large market, Fintech does not always require network effects. I use Lending Club (peer to peer lending), which makes money on arbitrage (gap between savings and credit card rates) and LC does not NEED scale to be profitable… On regulation, I’d say that it can be lighter when public risk is lighter. Should individuals be protected from themselves? Harder question?

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    1. Indeed, fintech is pluriform, and can have as many different forms as traditional banking has. This also implies different forms of regulation/policy for different kinds of fintech companies.

      Why does it not though? Does it not have any constant costs? Marketing to get more customers, etc.?

      On regulation, I totally agree, but I think right now we do not really know yet. It is an empirical question, on which research needs to be done asap.

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  2. Hi Joes,

    Interesting read, however when you say that “we can expect banks to lobby in favour of regulation of the fintech companies, because they represent a direct threat to traditional banking. We have to make sure that the traditional banking sector does not prevent fintech from becoming the next big thing, purely because fintech is dangerous to banks.” I think you’re wrong.

    The intuition behind this statement makes a lot of sense: Fintech companies will offer lower cost competition to established banks, therefore banks will try to prevent a fintech boom. You’re right that companies like Wealthfront and Transferwise’s business models rely on undercutting banks. However banks are central to the fintech economy. Every fintech accelerator and conference is supported or run by large banks and banks are keen to invest in fintech. This all probably comes down to the banks R&D costs, which are huge. Many banks still use mainframes from the 80s and rely on code written in COBOL. When it comes to innovating and competing with each other it becomes much easier for a bank to buy or partner with a fintech startup (which has a very low R&D cost) this why many fintech accelerators end with the opportunity to partner with a bank and to distribute the startups product through the banks channels.

    Finally a traditional bank is such a large and complicated institution that you can’t really just make a fintech bank. A fintech company would have to take aim at one of the many areas banks are present such as payments, investments or currency transfer and make that its bread and butter. If a startup approaches investors and says “I need 50 million dollars to start a better bank” I doubt they will be able raise the capital they need let alone compete with the giants who will mercilessly crush them with their outdated COBOL and oversized mainframes.

    PS: Not all fintech companies are P2P lending platforms or marketplaces of one kind or another (regarding your comments on liquidity) 🙂

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  3. Hey Sam,

    Thanks for your comment!
    Do you think there are specific sectors or services which will see a lot of competition between banks and fintech start ups, and sectors or services which will see more cooperation between banks and fintech start ups?

    With regards to the PS, indeed, it is a very diverse sector, as diverse as banks are. Difficult to pin it down, as ‘fintech’ refers to the medium used, rather than a specific service.

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    1. I imagine fintech companies that rely on undercutting banks in currency exchange rates and lending rates will see tough competition from banks, but basically everything else will find cooperation with banks! Especially startups in investments (Investech?).

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