In this talk, Prof. Liyan Yang compares open banking model and current closed banking model (hereafter current banking) when a depositor can renegotiate the interest rate with a bank after observing the bank's investment decision. Using a theoretical model, the paper shows that open banking improves borrowers welfare compared to current banking because of increased competition between banks. This result is consistent with the generally held arguments in favor of open banking. Surprisingly, however, the paper also shows that the introduction of an open banking lowers the social welfare compared to current banking.
There are three different agents in the model: a borrower, two banks, and a depositor. A borrower wants to finance a risky project, which can generate either R >0 or nothing. One of the two banks is home bank to a borrower. A home bank has transaction data on this borrower. Using the data and its own algorithm, a bank can observe some informative signal on whether this project is promising or not. Non-home bank cannot get access to the transaction data under current banking. Therefore, non-home bank's estimate of the project is the same as the prior. Lastly, there is a depositor who can monitor the bank's investment decision. After observing the bank's investment decision, the depositor will update her belief on the probability of the project's being successful, and then renegotiate the interest rate with a bank according to her posterior. This possibility of renegotiation plays an important role in deriving the main result of the paper.
Firstly, the model shows that under current banking a home bank becomes an information monopoly, which means that a home bank is the only practical bidder for the borrower's project. As a consequence, all the borrower's surplus is extracted by the home bank, and the project is surely funded whenever the home bank receives a good signal on the project. With open banking, on the other hand, the two banks end up not funding the project with some positive probability even when each of them receives a good signal of the project. This counter intuitive, at the same time interesting, result comes from the two elements in the model: winner's curse and depositor's renegotiation. Suppose bank 1 received a good signal of the project. In an open banking, both banks own the borrowers transaction data. Therefore, it is probable that the other bank received a bad signal, and bank 1 becomes too optimistic on the borrower's project. In other words, bank 1 can fall into winner's curse. Moreover, a bank takes into account the possibility of renegotiation with a depositor when making investment decision, which increases the financial cost of a bank. As a result, a bank sometimes does not bid for the project to compensate the risk of exacerbated winner's curse. The paper also shows that the possibility of depositor renegotiation is critical to the the main results.
With these equilibrium results, the paper compares various welfare results under the two alternative banking system: open and current banking models. First of all, a borrower is always better-off with open banking since she is offered a lower interest rate from the two competing banks. Next, the paper moves on to analyze resource allocation of the two bank models. First, the paper discusses funding efficiency, which is about how well high credit-quality borrowers are funded. The result shows that open banking outperforms current banking in terms of funding efficiency when R is high, but under-performs when R is low. Second, the comparison is made based on screening efficiency, which is about how well low credit-quality borrowers are screened. According to the paper, open banking outperforms the current banking in terms of screening efficiency when R is low, but under-performs when R is high. Surprisingly, however, the total welfare decreases when the society moves from current banking to open banking regardless of R.
In summary, open banking induces competition between the banks, and thus improves borrower's welfare. However, the competition between the banks gives rises to the possibility of winner's curse, which is also exacerbated by depositor's ability of renegotiation with the banks. A bank reacts to those risks sometimes by not funding the project even when it observes good signal of the project. As a result, the total welfare decreases under open banking compared to current banking system. This paper informs the current discussion on the social impact of introducing an open banking system. Especially, the paper points the importance of considering the risks related to financial system's health and stability as well as the risks related to consumer protection and privacy.
Liyan Yang is a Professor of Finance, Peter L. Mitchelson/SIT Investment Associates Foundation Chair in Investment Strategy at the Rotman School of Management, University of Toronto. His research interests are in financial markets, asset pricing, and behavioral finance. He is currently serving as an associate editor at Journal of Economic Theory, Journal of Finance, Journal of Financial Markets, Journal of Economic Dynamics and Control, and Management Science. His research has appeared in Journal of Economic Theory, Journal of Financial Economics, Journal of Finance, and Review of Financial Studies, etc. Yang has received the 2016 JFQA William F. Sharpe Award for Scholarship in Financial Research, the 2016 Bank of Canada's Governor's Award, and the 2015 Roger Martin Award for Excellence in Research, among others.
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