I have always found the idea of fintech beyond payments/transfers perplexing. I have blogged here, here, here, and here about fintech, micro-pensions, and financial engineering in general.
In the backdrop of Wirecard, Tamal Bandopadhyay has a very good article putting fintech in perspective. He writes about the importance of regulation of fintech providers,
Roughly, the fintechs here can be classified into three categories. The first set operates in the financial market as intermediaries between the customers on the one hand and the banks and NBFCs on the other, offering services ranging from customer acquisition to disbursing loans and collecting repayments; the second set operates in the insurance space; and the third set works for stock and commodity exchanges, broking firms, mutual funds, clearing houses, depository participants and even corporate houses (could be for systems application and data processing). The RBI, the Insurance Regulatory and Development Authority of India and the Securities and Exchange Board of India regulate, the entities that engage the fintech companies but the fintechs themselves are not regulated. That’s the crux of the problem.
Some of them make the most of the regulatory arbitrage. For instance, an NBFC needs 15 per cent capital adequacy ratio to run its business — a capital of Rs 5 for every Rs 100 worth of loan, depending on its risk weightage. A fintech can source money from an NBFC at, say, 14 per cent, acquire customers on its platform, and lend to them at, say, 22 per cent, keeping a wide margin. Typically, it offers a 5 to 10 per cent first loan default guarantee (FLDG) to the NBFC. This means, if a loan goes bad, the fintech takes the responsibility of making good up to this limit. So, the fintech can leverage itself 20 times (5 per cent FLDG for Rs 100 loan), that too with someone else’s money, while the NBFC is leveraged around seven times (15 per cent capital for Rs 100 loan). This makes it imperative for the fintechs to behave with responsibility and transparency.
With Wirecard, the focus on fintech regulation globally will only increase and regulatory arbitrage has to come down. But as Tamal cautions, regulatory oversight should not end up killing the innovations in this space.
There is another dimension to fintechs. In the impact investing world, it is the prevailing narrative that fintech providers are actually substitutes for banks and insurers. What is lacking is a realisation about what is the role that fintech providers can technically offer. This is a big problem,
The Reserve Bank of India (RBI) issued a release saying many fintech platforms “tend to portray themselves as lenders without disclosing the name of the bank and NBFC at the backend”... The RBI wants them to let the borrowers know which banks or NBFCs such platforms represent, sanction the loans on the letterhead of the banks and the NBFCs that are lending money and, finally, wants the lenders to take the responsibility to ensure that such platforms behave well. In other words, such platforms should function the same way the banking correspondents (BCs) do. The BCs are engaged by banks for loan disbursements and deposit collections.
I can understand fintechs in digital money transfers and payment services. That's their terrain. I can also understand them doing intermediation between banks/NBFCs and borrowers/depositors. But I cannot understand the idea of a full-service financial products (selling savings, loans, and insurance products) fintech. I struggle to understand how such a creature can exist at scale.
It is therefore not surprising that there is not one fintech provider outside of China (where they have their unique reasons) that has scaled. Not one even in the US. There is a compelling argument that the techfin trend, where the likes of Google, Facebook, and Amazon get into digital finance, is emerging only because of their access to ultra-cheap capital from the extraordinary monetary accommodation. For sure, they are well placed to do payments/transfers, but beyond that it is difficult to imagine a sustainable business model without the Fed's misguided benevolence.
The fundamental problem with fintechs is the viability of their business model. In the absence of a banking license, a fintech company does not have access to lower cost capital. If it tries to lend with higher cost capital, then it is surviving on a regulatory arbitrage which can be plugged anytime besides having to offer capital to retail customers at no better rates than that offered by the more benign money lenders. And you cannot have a business model intermediating higher cost long-term capital (raised from bonds etc) to essentially do short-term lending (which is what retail customers want from their banks).
Then there is the issue of desirability. If we believe they have a role to play in supporting banks with financial intermediation (identifying and screening borrowers), then we run into the issue of banks ending up outsourcing credit origination. Do we want to encourage the practice of banks moving away from an incentive compatible relationship banking towards an outsourced credit origination model, and that too in weak regulatory environment contexts, and thereby set the stage for financial market problems and distortions? We all know the adverse consequences of perverse incentive problems from taking mortgage and credit card loans out of banking balance sheets through securitisation.
Even on the credit-worthiness assessments and big data/AI, there are now emerging limitations to the role of fintechs. See this and this.
In summary fintech companies perhaps have two roles. One, as a digital payments/transfers provider. Two, as an efficiency enhancing force in banking and downstream financial intermediation.
Update 1 (10.06.2022)
TT Rammohan has this article where he feels apart from forcing banks to pull up their socks and improve productivity, fintechs are unlikely to do much. He writes about the threats likely from full-fledged digital banks
Digital banks don’t quite take banks head-on. They typically target high risk customers that banks tend to avoid. These include: Individuals with lower incomes or lower credit scores, commercial real estate and unsecured lending. Despite the higher risks they take, digital banks have a lower provision coverage than traditional banks. Their yields on loans are about the same. They have a less loyal depositor base but their liquidity ratios are lower. Digital banks’ potential for fee income is lower because they deal with lower income clients. You might think they would have lower operating expenses because of the absence of brick-and-mortar. Not at all. What they save on branches is more than offset by huge marketing expenses. Not surprisingly, most are loss-making. So much for digital banks threatening traditional banks and taking away market share from them. Digital banks are connected with banks through the inter-bank market and also through the various services they provide. They are lightly regulated at the moment. But as they grow bigger, regulation will have to be tightened, as the GSFR report observes. Digital banks are a threat, not so much to banks, as to banking stability on account of the systemic risk they pose.
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