FinTech vs. Banks: Who Will Win the Battle for Your Money?

FinTech, or financial technology, is a term that refers to the use of digital platforms and innovations to provide financial services. FinTech firms have emerged as new players in the global financial landscape, offering faster, cheaper, and more convenient solutions to customers.

But how does FinTech affect the performance and profitability of traditional financial institutions (FIs), such as banks and non-banks?

Are FinTech firms complements or substitutes to incumbents?

And what are the implications for the financial system and regulation?

In this blog post, we will explore these questions based on a recent IMF working paper by Ben Naceur and others (2023). We will explain the main findings, the underlying mechanisms, and the policy implications of the paper. We will also provide some examples, data, and insights from other sources to enrich our analysis. By the end of this post, you will have a better understanding of the impact of FinTech on the financial industry and the challenges and opportunities it poses.

Read my other posts here: Conventional Finance - FinFormed, Islamic Finance - FinFormed, Takaful - FinFormed, Career - FinFormed and Randow Writings - FinFormed

The Complementarity vs. Substitution Hypothesis

The paper starts by presenting two competing hypotheses on how FinTech affects the profitability of incumbent FIs.

The first one is the complementarity hypothesis, which suggests that FinTech presence enhances the performance of incumbents by creating synergies and partnerships.

The second one is the substitution hypothesis, which implies that FinTech presence reduces the profitability of incumbents by increasing competition and eroding market share.

The complementarity hypothesis is based on the idea that FinTech firms can help incumbents improve their operational efficiency, expand their product offerings, and strengthen their customer relationships. For example, incumbents can partner with FinTech firms to outsource some of their functions, such as customer onboarding, verification, credit scoring, loan processing, and data storage. This can reduce transaction and monitoring costs, and facilitate faster service delivery. Incumbents can also leverage FinTech platforms to access new segments of customers, such as underserved or less creditworthy borrowers, and diversify their revenue streams. Moreover, incumbents can invest in their own FinTech solutions to enhance their digital capabilities and meet customer expectations.

The substitution hypothesis, on the other hand, is based on the idea that FinTech firms can disrupt the financial landscape by offering superior user experiences and lower prices. FinTech firms can leverage their technological advantages to provide more efficient and convenient services to customers, such as online lending, mobile payments, and robo-advisory. FinTech firms can also exploit the regulatory gaps and arbitrage opportunities that exist in the financial system, as they are not subject to the same level of scrutiny and requirements as incumbents. This can give them a competitive edge over incumbents, especially during periods of regulatory shocks, such as higher capital requirements. As a result, FinTech firms can capture a significant share of the market, reducing the interest income and fee income of incumbents, and increasing their operational costs.

The Empirical Evidence

To test these hypotheses, the paper uses a comprehensive cross-country database that covers 10,167 FIs and data on FinTech transactions across 57 countries from 2012 to 2020.

The main finding of the paper is that

FinTech presence has a negative and significant impact on the profitability of incumbent FIs, supporting the substitution hypothesis.
The paper also finds that FinTech presence reduces the net interest margin and increases the cost-to-income ratio of incumbents, indicating that FinTech competition erodes the interest income and raises the operational costs of incumbents.
The only positive effect of FinTech presence is on the non-interest income of incumbents, suggesting that incumbents try to diversify their revenue sources, but this is not enough to offset the losses from FinTech competition.

The Role of FinTech Business Models and Bank Types

The paper also examines how the impact of FinTech varies depending on the specific FinTech business models and the types of FIs involved. Among the various FinTech business models, the paper focuses on two: P2P lending and Balance Sheet lending, which account for the majority of FinTech transactions.

P2P lending refers to platforms that match borrowers and lenders, without intermediating the loans themselves.

Balance Sheet lending refers to platforms that originate and service the loans themselves, using their own or borrowed funds.

The paper finds that different FinTech business models have different effects on FIs.

P2P lending has a negative effect on the profitability of FIs, especially cooperative banks, which are more vulnerable to FinTech competition due to their smaller size, limited product range, and local customer focus.

Balance Sheet lending, on the other hand, has a positive effect on the profitability of FIs, especially commercial banks, which are more resilient to FinTech competition due to their larger size, broader product offerings, and existing investments in digital technology.

The paper also finds that commercial banks benefit from partnering with P2P platforms, as they can generate additional non-interest income from fees and commissions.

The Role of Country and Bank-Specific Characteristics

The paper also explores how the impact of FinTech varies depending on the characteristics of the countries and banks where FIs operate. The paper considers various factors, such as the level of financial development, the degree of financial system competition and profitability, the strength of the regulatory framework, the risk-taking behavior, the asset quality, and the capital adequacy of FIs.

The paper finds that the impact of FinTech is more negative for FIs in countries with more competitive, profitable, and developed financial systems, as they face more intense FinTech competition. However, the paper also finds that the impact of FinTech is more positive for FIs in countries with stronger regulatory frameworks, as they benefit from a level playing field that fosters innovation and protects incumbents from unfair practices. Moreover, the paper finds that the impact of FinTech is more negative for FIs with higher risk-taking, lower asset quality, and lower capital adequacy, as they are more vulnerable to FinTech disruption.

Conclusion and Policy Implications

The paper concludes that FinTech presence has a significant and negative impact on the profitability of incumbent FIs, supporting the substitution hypothesis. The paper also shows that the impact of FinTech varies depending on the FinTech business models, the types of FIs, and the country and bank-specific characteristics. The paper provides some policy implications for regulators and policymakers, such as:

Enhancing the regulatory framework to ensure a level playing field, foster innovation, and protect consumers and financial stability.
Promoting collaboration and cooperation between FinTech firms and incumbent FIs to create synergies and partnerships.
Encouraging investment and adoption of digital technologies by incumbent FIs to enhance their efficiency and competitiveness.
Strengthening the supervision and monitoring of FinTech activities and risks to prevent regulatory arbitrage and financial instability.

Key Takeaways

FinTech refers to the use of digital platforms and innovations to provide financial services.
FinTech affects the profitability of incumbent FIs through two competing hypotheses: complementarity and substitution.
The paper finds evidence for the substitution hypothesis, as FinTech presence reduces the profitability of incumbent FIs.
The paper also finds that the impact of FinTech varies depending on the FinTech business models, the types of FIs, and the country and bank-specific characteristics.
The paper provides some policy implications for regulators and policymakers to address the challenges and opportunities posed by FinTech.

P.S. What are your thoughts on FinTech and its impact on the financial industry? Share your comments below.

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

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