FinTech or financial technology has become an industry of great interest for investors, financial service professionals, consumers, businesses, and policymakers. From 2012 to 2017 Q2, VC-backed FinTech firms raised $50 billion globally (see CB Insights). Additionally, several central banks and international agencies have formed working groups with FinTech leaders or created sandboxes (see IMF and Bank of England). In this blog, I will discuss what is different about today’s financial technology providers, how the FinTech industry improves financial products, and how FinTech firms compete and partner with incumbent financial institutions.
The introduction and adoption of financial technology are not new. Mobile banking, payment card terminals, and credit scoring algorithms were all financial technologies that improved access to financial services for consumers and businesses. However, unlike financial technology providers of the past, many FinTech firms today interface directly with their customers. FinTech firms aim to fundamentally change the delivery of financial services by enabling seamless exchange of information while also offering greater transparency at a lower cost and increased access and convenience. Some experts go further in their definition of FinTech firms as those that eliminate or reduce human interaction in financial transactions and may classify some incumbent financial institutions as FinTech firms (see Heinrichs). For the purposes of this discussion, I separate FinTech firms from traditional financial institutions such as depository institutions, asset managers, insurance companies, and investment banks although such distinctions continue to blur and may not exist in the future.
Over the past couple of decades, there have been fundamental changes in globalization (mobility of labor, goods, and technology across borders), commerce among unknown parties, increased regulation of incumbent financial institutions due to the recent financial crisis, and a greater focus on financial inclusion. These trends, coupled with advances in technology such as mobile 24/7 connectivity, greater usage of application protocol interfaces (APIs), cloud technologies, machine learning, and artificial intelligence have created and continue to create greater incentives for new firms to enter the financial services industry. I identify four areas that FinTech firms expand upon and compete with incumbent financial institutions: (1) acquiring customers with better customization and greater convenience, (2) providing financial services for underserved market segments, (3) expanding consumer and business access to financial products, and (4) reducing the cost of financial services. In basic economic terms, FinTech firms reduce frictions from financial decisions and transactions.
Consumers and businesses are increasingly recognizing nonbank brands for financial services such as Lending Club and Venmo because of the ease of use and convenience of their products. These providers acquire customers virtually and have relatively fast onboarding and approval processes. For example, recently while at a tutoring session, my teenage daughter was able to open a new Venmo account and make a payment within minutes. In some cases, customers may be willing to pay convenience premiums. In a recent study, Buchak, Matvos, Piskorski, and Seru found that FinTech lenders, defined as the application and approval process completely done online and quickly, on average charge a 14-16 basis point premium versus traditional lenders. As we will discuss below, the entry by these firms is dependent upon incumbent firms not adequately serving some market segments or groups of customers.
FinTech firms often target niche areas where incumbent financial service providers are not offering products that are well suited for a specific market segment. For example, PayPal became the payment option of choice on eBay because, at the time, individuals could not easily accept payment cards or ACH payments. PayPal offered a user-friendly interface at low cost (initially, both payers and payors received monetary incentives to use PayPal). Although eBay had developed its own payment mechanism with the involvement of a large bank, eBay buyers and sellers preferred PayPal. Once PayPal successfully captured payments on eBay, it expanded to other payment forms. What PayPal did for online purchases, Square provided for small merchants at the point of sale. In fact, many U.S. cab drivers use Square to receive funds faster and cheaper than payment processors used by their cab companies.
FinTech firms increase access to financial services for individuals and small businesses. For example, small businesses and individuals may not be granted credit from incumbents because they lack adequate collateral, do not have sufficient credit history or traditional metrics do not capture their credit risk. There are various online alternative lenders that are filling these niches. The funding of these loans may result from a matching process between borrowers and lenders, direct lending, or partnering with banks. Recently, Amazon and PayPal have extended small business loans based on inventory and payment flows.
In a recent study, Jagtiani and Lemieux found that Lending Club has filled a credit gap and have offered lower rates to individuals with similar creditworthiness than traditional lenders. Specifically, they find that using alternative data to traditional credit metrics, Lending Club slotted borrowers that may have been classified as subprime using traditional measures into “better” loan grades resulting in lower-priced credit. Jagtiani and Lemieux give examples of these alternative data sources. These sources include utility payments, deposit and withdrawals transaction accounts, insurance claims, and the use of mobile phones or the Internet. In addition, those with the same risk of default paid smaller spreads on loans from Lending Club. In addition, Buchak, Matvos, Piskorski, and Seru find that greater regulation of incumbent mortgage lenders has increased nonbank lending including FinTech mortgage lenders.
FinTech firms often are able to provide services at a lower cost than incumbent providers. For example, asset managers, Betterment and Wealthfront, commonly referred to as Robo-advisors, provide financial investment options where their customers are put into different types of investments based on their preferences to risk, return, and stage of life. While there is no human financial advisor, the portfolio is customized and may rebalance automatically. These firms are able to provide their services at a lower cost because of automation and the use of low-cost exchange-traded funds. However, the long-term viability of these firms is dependent on their ability to scale. In a 2015 report, Morningstar calculated that the breakeven level is between $16 billion to $40 billion assets under management (AUM). Based on these figures, the leading Robo-advisors would need between 8 to 20 times of their 2015 AUM to recoup their costs. Furthermore, incumbent firms such as Blackrock, Charles Schwab, and Vanguard have also launched Robo-advising platforms; increasing competition for pure Robo-advisors.
As the number of FinTech firms continues to grow, what will be the responses from the incumbents? In some cases, larger incumbents are investing in technological improvements of their own. However, to reach ubiquity many of these financial institutions are collaborating with their peers. For example, the banking industry is promoting Zelle as their peer-to-peer payment mechanism to compete with Venmo.
In other cases, incumbents are partnering in various ways with FinTech firms. For example, FinTech lenders are generally only originators of loans. Recently, however, some FinTech firms such as SoFi and Square have applied for ILC (industrial loan company) charters to be able to provide loans directly. Incumbent financial institutions are also investing in FinTech firms at different stages of development and, in some cases, allowing these firms to access their customers. In addition, many incumbents have created venture capital arms and are actively participating in accelerators.
In the end, consumers and businesses will benefit from the rapid innovation occurring in financial services. Nonetheless, similar to any period of rapid innovation, there will be winners and losers among incumbents and new entrants alike. However, unlike disruption in other industries, incumbent financial service providers will not completely disappear but will have to up their game in terms of convenience, customization, access, and cost.