Nout Wellink, Member of IMI International Committee; Former Governor, The Netherlands Bank

Introduction

Technological developments not only affect banks and other institutions delivering financial services (such as insurance companies), but also central banks and regulators/supervisors. An important issue is how the financial sector and the authorities operating in this sector should deal with fintech/big tech companies. The meteoric rise of these companies raises also broader and more fundamental issues as to their role and position in our societies.

Focusing on banks, the first question that arises is whether the several thousands of fintech companies that have now been established will ultimately undermine the business model of traditional banks or whether these companies will be absorbed by the banking system. Many small fintech companies will eventually fail. They may not develop enough scale or are not able to mobilize enough financial resources to pose a real threat to the banking system. Life is not easy for these newcomers to the financial sector. Under existing legislation, they must comply with all legal conditions that are imposed on banks. That means, for example, that they must meet all requirements for the gatekeeper function regarding money laundering. These requirements are financially very heavy for a small company (high compliance costs). That is why these companies are often absorbed by banks, who thus try and make the innovative strength of the fintech’s part of their business.

We are indeed seeing more and more mergers and partnerships between established financial institutions and fintech startups, but these are not always happy marriages. The integration of a fintech startup into a traditional bank is less simple than is often thought, partly because of cultural and management differences. These “marriages” are, therefore, regularly followed by a divorce.

The real competition for the banking industry doesn’t come from small independent fintech companies, but from the explosively growing internet giants. There will be, of course, exceptions, because small companies can become big by operating very successfully or by merging with other fintech companies. As of the beginning of this year the number of unicorns fintech’s (companies with a valuation over $ 1 billion) is still relatively limited. Therefore, the focus in the following is on the (very) large, technologically advanced companies, with a wide range of activities, that increasingly also provide financial services.

Disappearing competitive advantages

A major strength of banks was their close relationship with the customer. Since a large part of the services of banks is seen as a public good, their business is highly regulated and protected from outside competition. Consumers derive confidence in the banks from this, but it made banks cost-inefficient. They also had somewhat forgotten their primary focus on the customer. That became abundantly clear during the financial crisis. Angry consumers looked for alternative providers of financial services (fintech companies) and alternative money (crypto currencies). Technological developments contributed in many countries to an increasing erosion of the close relationship between banks and their individual customers too. In the past, in financially developed countries large banks had a dense network of local branches and, in addition, there were also many small banks that were close to the citizen. Forced by competition and made possible by new technologies, banks in these countries had started to shrink their network. At the same time, many smaller banks had merged into larger ones.

While the market position of traditional banks relatively weakened (there are of course always exemptions), big tech companies gained in strength. At this moment the cumulative market cap of the seven “biggest techs” is already much larger than of the top 200 (highly regulated) banks. That was different a few years ago, for various reasons. Big Techs operate in many fields, getting information about their customers from all corners of the internet. The core of the fintech approach is to understand what the customer wants and to deploy technological solutions to fulfill these wishes. Therefore, Big Techs exploit to the fullest, in a cost-efficient way, their large data files with artificial intelligence. The corona crisis has given a strong, further boost to technology firms, but undoubtedly also their improved performance and more active involvement in financial services have played a role. Big banks have large data files too, but these are less diversified. In addition, banks not always realize the value of their data and are also more restricted in the use of them. Unlike the banks had become, big tech companies are very customer-oriented, sometimes operate on or beyond what is legally permissible, and they are less hindered by regulations

For banks, part of the answer to these developments was entering into partnerships not only with small fintech’s, as mentioned above, but also with these big tech companies. This is kind of a two-edged sword. Already as early as 2016 the World Economic Forum warned that these partnerships also carry risks. Banks could become too dependent on Big Techs; their fees could come under pressure, and they could also lose much of their own identity because of the strong(er) brand of the big tech company. For banks, finding the right balance between cooperation and competition is a very delicate process.

Survival of the fittest

Bill Gates proclaimed as early as 1994 that: "banks are dinosaurs, (...). We can bypass them." For the banks today, as I once read, the task is "how to make the dinosaurs run”. In any case, banks need to get rid of the IT legacy of the past. Much of the banking industry still struggles with outdated mainframes and software. The maintenance of the old IT configuration (often with different program languages and machines) is complex and costs a lot of money. Unfortunately, this also applies to the transfer of data and applications to the cloud. But once all that has happened, the costs will drop significantly. The transition to new systems is not only a question of money, but often also, technically, extremely complex because of "spaghetti connections": everything is interlinked. These are all reasons why the introduction of new technologies can be faster in financially less advanced countries. These countries can start from scratch.

The threat to the traditional banking system lies primarily in the payment system and directly related services. That threat has now become even greater for technologically lagging banks, because the corona crisis has given a significant, further impulse to digital and contactless payments. Fintech, defined as innovative digital technology solutions aimed at optimizing financial services and banking, is advancing mercilessly as part of the activities of big tech companies. Not only in China, but also internet giants in the West are eager to jump into the payment system, and in insurance, money management and lending. The entire payment system field is changing rapidly. Bad luck for those small banks that - often supported by politics - want to focus as much as possible on the utility function (payment, saving and safe investment). Without full swing innovating and digitalizing, this utility function eludes them, and the so cherished security of these banks will eventually turn out to be a bad dream.

The threat from the fintech angle extends to the entire package of banking activities. This is what see happening now. In some countries, such as China (Alibaba, Tencent) but also in the US (Google, Apple) this development is more advanced than in others. It is the combination of new technologies and changing consumer preferences that is driving the transformation process in the financial sector. An important corollary of these developments is that, thanks to the new business models that are emerging, a much more inclusive financial system is emerging.

If the fintech approach, which is taking hold in many areas of the banking business, continues - and there is no reason to suppose that it should not - only the business model of the bank, which is also a sufficiently advanced high-tech company, will have in the somewhat further future still life chances. Banks that want to remain viable must have an encompassing data strategy and will have to move from just IT-based banking (the simple use of computers) to smart banking. They will have to use artificial intelligence to fulfill as many (of the continuously changing) wishes of its customers as possible, not only doing things better and faster than in the past but also and especially by product innovation (e.g. products that consumers believe will improve their financial health). All these developments require new organizational models for banks as well as a different kind of workforce. "Adapt or die," writes Brett King in his fascinating book “Bank 4.0”. The ability to adapt a bank’s organization is a condition of life.

Policies of the authorities

Innovation should not be nipped in the bud and big tech is an important source of innovation. But it should also not endanger the stability of the financial system, threaten privacy and undermine the necessary level playing field in the economy. Fintech has had a positive impact on the financial sector, as it has shaken up the banking sector and made this sector aware of the need to better serve the customer and to work more efficiently. Because of the easy profits that could be made in the past, banks kind of forgot about that.

Life was perhaps too easy for central banks too. The banknote monopoly, their monetary policy instruments, their formal and informal command over the banks and their authority more generally had made them a bit sleepy. In addition, many central banks in countries with well-developed payments systems initially remained rather skeptical (some of them still are) about the value added of an official digital currency. Fortunately, the mood at the majority of central banks has changed. Facebook’s Libra-initiative (Facebook has nearly 3 billion monthly users) has undoubtedly been instrumental in this regard. Most central banks are now working hard to develop a digital currency that is also legal tender and, therefore, has a competitive advantage over cryptos. They realize that current technological developments can hit the heart of their activities. Hopefully, central banks will combine forces and also work on common, international standards.

China is well ahead of most other central banks with the development of its digital currency and is already in the pilot stage. The US Fed is still evaluating whether to launch a digital currency, but the ECB officially launched in July 2021 its digital euro project, because it wants to protect its monetary sovereignty and to preserve its citizens’ access to central bank money in case cash would disappear. But it will be years before there is a digital euro.

While providing an official alternative, central banks and regulators worldwide should also regulate (or ban altogether) cryptocurrencies and stable(value)coins. Stablecoins suggest more stability and safety than they can actually deliver, due to insufficient and/or illiquid reserves to serve as a backing. A chaotic situation is developing with respect to cryptos. Cryptocurrencies, “created by the people and for the people” as the slogan goes - there are now around 12.000 of them - can infect the financial system the moment the crypto- and the official money circuits come into contact. Crypto’s facilitate criminal payments, their production is extremely energy intensive, they may be prone to runs and do not offer any protection to unsuspected owners. The Chinese central bank recently stated that all transactions related to crypto’s – also those provided by foreign platforms to Chinese residents – are illegal, which I believe is completely justified. An alternative for banning them completely would be to try and bring them under existing regulation regarding banks and/or securities.

Financial regulators/supervisors have their own role to play, but there are, of course, overlapping fields of activity with central banks. While central banks mainly focus on the integrity of the value of money (price stability), the efficiency of the payments system and the stability of the financial system, the attention of financial regulators is primarily focused on the health and integrity of individual financial institutions. But the problem of the big techs is broader than the financial sector. There are also issues related to consumer protection, privacy, monopolistic practices, data governance (ownership, collection, storage), etc. In fact, a strategy that encompasses all these aspects is necessary. Regarding banking supervision, a great deal of harmonization has taken place internationally. As to the other aspects mentioned, international views often differ quite a bit and national solutions, therefore, also differ. Authorities should try and work on harmonization of these aspects too.

Big Tech companies operate with the help of existing infrastructures or via systems proprietary to them. This is a stylized representation of reality. In practice, these models overlap. In the first approach the tech firm is a third party, for which the bank bears responsibility and supervision is entirely conducted through the bank. In the second approach supervision on the financial activities is activity based, but much more complex because of opaque governance structures.

Developments now are moving at an almost lightning speed, for example regarding the role of technology companies in bringing online banking to the cloud. China has four rapidly growing cloud giants, and they are instrumental in the upgrading of the traditional industries, including the financial sector. This a welcome development. The cloud approach is very efficient, but what if a cloud company runs into problems? Then banks, and perhaps also the financial system, will get into big trouble. Therefore, the risks involved in reliance on third parties (in this context big tech companies) for very essential services, have become a major concern for supervisors. No wonder that the EU – other jurisdictions are moving into the same direction - has published in September 2021 a legislative proposal aimed at bringing “critical ICT third party providers”, including cloud service providers, within the regulatory perimeter, so as to strengthen the operational resilience of the financial sector and of the individual firms within it. This is an important step forwards, because it brings certain “critical” activities of the big techs under kind of direct supervision. This is an inevitable move, seen also in other jurisdictions, from activity based to entity-based supervision on providers of financial services outside the regulated financial sector. That said, banks remain, of course, responsible for their control environment.

Even more complex is finding a solution for a big tech company that operates in many areas, including financial ones, via its own systems. Technological developments make it easier – via Application Programming Interfaces – to embed banking services into any product a tech company wants to sell. To come to grips with such a company and to create a situation in which their financial services can be regulated and supervised adequately, a transparent structure is a necessary condition, whereby on the one hand banking activities are separated as much as possible from other services and on the other hand efficiency gains and consumer preferences must be taken into account. An interesting example is the restructuring of Ant’s Alipay. This restructuring not only addresses typically financial sector issues, but also competition- and data governance issues (ownership, access, privacy, usage). The approach regarding data governance has China specific characteristics. The user data, collected via super-app Alipay, will be turned over to a partly state-owned joint venture. This joint venture will apply for a consumer credit scoring license and future lending decisions by Alipay will be based on data from this credit scoring firm. This is in line with the policy of the central bank that credit decisions should be based on data from approved credit scoring companies.

A closing remark of a general nature

Big Tech companies bring efficiency gains and (financial) inclusion. But the question remains to what extent they distort fair competition, misuse data and can be trusted to serve the public interest. Do they focus sufficiently enoughy on solving the major issues of our time, such as the climate, healthcare, infrastructure, etc. Nowadays, in many countries essential parts of the critical infrastructure (including the financial sector) are in the hands of the private sector, often without sufficient supervision and without regulation that adequately protects the interests of the society.

If we do not want Big Techs to rule the world unchecked, something should be done. Internationally, not only in China but also in the US and Europe, the authorities have become more active by closely scrutinizing Big Tech amid potential anti-competitive and financial stability concerns and by introducing legislation to address these concerns. These policies are an important step in the right direction, but only part of the solution. There is also a need to strengthen the position of those operating the public interest. Various solutions are conceivable here. I will just mention one.

In the past, governments were often the driving force for technological innovations. The internet originated in the defense world and the spin-offs of the race to the moon has been enormous: NASA identified more than 2000 of them since 1976. Today, this innovation role seems to be taken over in many countries by Big Techs and its leaders who are nowadays sending rockets into space. Their companies derive their dominant position from the collection and analysis, with artificial intelligence, of huge data files. This immediately points to a direction in which important progress could be made. If the public sector is to compete with the Big Techs, it must encourage data sharing, for example between scientists, within a country and cross-border, and therefore create national and international research clouds that allow academics and others to access massive, public datasets. Recently, interesting initiatives in this area have been taken in the US. Legislation in that country requires a federal task force be established “to study and provide an implementation pathway to create world-class computational resources and robust government datasets by researchers across the country in the form of a National Research Cloud”. This kind of initiatives are a useful, positive response to the growing power of the Big Techs. They strengthen the position of those who primarily work in the public interest and don’t weaken the innovation capacity of others.

These initiatives should not remain just national endeavors. There are important areas where a cross-border approach would be helpful and/or urgently needed. Health, for example, is one such area. Research data on health should be seen as a global public good. I am fully aware of all the complications involved, especially with respect to privacy and security. The stronger the privacy legislation in a specific country, the more difficult it becomes to share information, especially cross-border. A good example is EU’s General Data Protection Regulation” that collides with legislation in other jurisdictions in which privacy issues are regulated differently. Security considerations are also a good example. The fewer countries trust each other, all the less they are inclined to exchange information on security grounds. But that said, there are many cross- border areas for which a (perhaps not perfect) solution must be sought and can be found. A positive example is the COVID-19 Data Exchange platform that acts as a trusted third party and in which all kind of guarantees are built in to comply with existing national regulations.

Common problems can only be solved together. In doing so, public authorities should take the lead, create a level playing field and not blindly trust on the private sector, of course without impairing the capacity of that sector to contribute to the solution of the enormous challenges in front of us.