Xavier Vives, IESE Professor of Economics and Finance, presented at Luohan Academy's Frontier Dialogue. Jon Frost, Senior Economist at BIS, discussed Vives's presentation. The following texts features transcripted excerpts from. It has been lightly edited for clarity and length.
Speaker presentation by Xavier Vives
Thank you very much for inviting me to be in this very interesting session. I will talk mostly about the new entrants and incumbents and competitive strategies or cooperative strategies between them. And I based my comments on some relatively recent work, which I have published in the Annual Review of Financial Economics, and also in a report of the banking initiative here at IESE. Let me just start very briefly, although quite a few things have been said by the people that have preceded me, that the impact of feedback and big tech is important and rising, but differential. It is not uniform across regions and jurisdictions and sectors. It's quite important in payments. For example, it is now impacting not only national payments, but cross border payments are quite important and growingly important credits and mortgages in the US.
It has extended the market, allowing much more financial inclusion of people, in particular, in emerging and developing countries that have no access to financial services. We have seen these already today. Another point that I think has already been made, all these in particular in emerging and developing economies has been allowed or has been possible because of technological leapfrogging. People that have never had a bank account will pay by mobile phone. Lending, in particular, by BigTech and FinTech in general is raising rapidly, but there are differences among regions. Typically, BigTech is gaining and has gained more traction in emerging and developing economies while FinTech has gained more other feedbacks, if you want the service that is not provided by BigTech platforms. They haven’t made more in roads in more advanced economies. Here we see, for example, big tech being more predominant in Argentina, Brazil, China, than in the United Kingdom or the United States where other feedbacks are mutually important. South Korea is a particular case.
Let me highlight the points in a few minutes. What are the advantages and disadvantages of FinTech? The advantage, superior technology, which is free of legacy systems. For example, we'll have to use the mainframe, the heavy and not flexible mainframes, and you can use directly cloud computing and leaner operation systems. It has a friendly consumer interface, which is new standard for consumer experience in particular, based on the mobile phone. They focus on activities and business segments with higher returns. For example, payments and cross payments where the intermediation margins were quite fat. And there was quite a bit of inefficiency as we have seen also in our talks today. Also, they typically have been operating with more equity funding than banks, although this is variable and it may depend on sectors.
Quite importantly, it has been able to attract the best talents. The most talented students do not want to work for a financial system, but they do want to work for a BigTech or FinTech. What are the disadvantages? The absence of an installed and loyal customer base, because there are entrants, some obviously are getting there, but not when they start. Limited access to stock information, despite these, they may compensate with advanced technology like machine learning to transform some of these digital footprints into hard information. A lack of reputation and brand recognition because they are entrants, and also high cost of capital and a small balance sheet. Although in some cases like in the US for example, a small balance sheet has not been an obstacle for mortgage lenders for example. To operate, because they sell basically, they package then sell the loans to the government sponsored enterprises.
Finally, they have a lack of regulatory and risk management expertise and experience. This is quite important because this is very regulated sector and usually you do not want to upset the regulator. And no access to the central bank backstop without a banking license. All these are advantages and disadvantages of Fintechs, which we may say for entrants or a small firm. When we get to Bigtech platforms, in principle, they have all the advantages. But with almost none of the drawbacks except the last, the regulatory and central bank access to the, and access to a central bank backstop. Plus, they have lots of data, exploitation of network economies, advanced technology to process information like in with machine learning. We've seen they may use this technology analyzing digital footprints may do better than credit growth and the traditional technology. For example, for credit ratings, they have a deep pocket and also lobby power. These means that BigTechs in principle have a potential more severe disruption capacity for the traditional banking business.
Now, to what extent the emergence of FinTech in general will make banking more contestable? I think it is, but we'll have to provide some caveats because there are some countervailing effects. Definitely there are more efficient technology and competitive pressure, but we have to also think that even in the digital world, there are quite a bit of endogenous and exogenous switching costs and monopolization possibilities that we will discuss. Also, the enhanced price transparency brought by digital technology may have ambiguous dynamic pricing effects. I will not have time to talk about today. Let's go back to the strategies of the incumbents and the FinTechs. Let's think rather now about the small entrants of FinTechs. What are the potential strategies of those FinTechs?
A forced idea is that they may commit to remain small and what it in terminology would be to remain like a puppy dog, which is not threatening, maybe even not get a banking license, form partnerships and collaborate with incumbents, serve unbanked segments of the population and their full unit compete directly, obviously with the banks. Because of not serving, you'll be more aggressive, basically coping more head-to-head entry, maybe as a licensed digital bank. This has been less likely given the high compliance cost involved, but we see that some are taking in this route. We'll see what happens in the end, whether they consolidate, sell incumbents or grow to be a full-fledged financial entity.
What about incumbents? Well, the incumbents may discriminate by segment, and again, may have two types of strategy, accommodate or fight, right? If they accommodate then, in the animal terminology, it would be like a peaceful fat cat. That will obviously say, "Okay, I'll let you in. There are high switching costs. Or I may even charge you some interchange fees to get to my base, and so on." We coexist or fight, like even trying to prevent entry or limit re-entry, the top dog strategy, maybe shut down or degrade backstage to the infrastructure to make life difficult for the entrants. Obviously, some banks have done that, launching their own fully online bank. Some of the more savvy incumbents are launching full online banks to test the waters and also compete with the FinTechs.
What about the BigTechs? The BigTechs, again, they have in general, the same type of taxonomy in terms of the strategies. They can accommodate or fight, I would say. Accommodating means to form partnerships. There is quite a bit exploration. CP has a partnership with Google because CP is already present in some major cities and to get more deposits partners with Google. Google gets information in exchange. That's one example, and credit cards or credit with Amazon and Bank of America, Apple, Goldman Sachs, et cetera. There are some partnerships which are part probably in preparation and part of it in testing the waters.
Or they can try to compete more head-to-head. One strategy, which is not the one we see for now, is to become banks' intermediaries, full-fledged banks with a banking license, exporting all the modeling they're offering, exporting all the economies of scope they made. But obviously, if they become banks and accept deposits, then they are subject to regulation or they may fall short of that because then the regulatory job may be impossible. Or they may just take the steps to be a multi-sided platform, a marketplace, where in this platform, basically they do whatever the others do, but better. And they try to monopolize the interface with customers with their ecosystem and then basically have all the financial providers to go through that platform.
In fact, let me just explain this graphically and I'll come back to the incumbents. This would be something like this, a future where we'll be financial services providers, which basically go through a platform to sell their products. Basically, all products would be sold eventually, or mostly all products, in a platform which could be in the ecosystem of a Fintech or with an incumbent, which has been trans-platformed and transformed.
The incumbents, let me just take a step back for a moment, may again accommodate or fight. Accommodate with the partnerships that we have seen, the examples I have put, or maybe providing some specialized unique banking services on products, or fight, compete head-to-head, also by becoming a platform or a marketplace, like I said here.
There are some pros and cons giving you an advantage or disadvantages that incumbents have. They may profit from superior trust, from customers on data security. Many people probably would rather trust their bank with financial data than Facebook, let's say, just to put an example. Also, they have better regulatory navigation skills and similar lobbying power than big tech. But what they cannot do is match really the big techs' modeling cross-subsidization strategy so that, in a sense, the ecosystem of the big techs is much larger and deeper, which can grow financial connection in many dimensions, which for the incumbent is much more difficult.
The question is whether we're moving towards kind of a new platform-based oligopoly with some BigTechs and platform-transformed incumbents to distribute financial products to different ecosystems. And then the question is, what degree of competition is really there? What's clear is that, at the beginning, the impact of digital disruption will be very strong. This will have an impact on banking. This is happening and fast, for example, in payments, in cross-payments and even in some credit product motivators, et cetera, and increased competitive pressure and contestability.
Obviously, this means, and as it is happening, incumbents have to restructure. They have overcapacity in branches. They have to invest more heavily in financial technology. There is a lot of consolidation in Europe. In Spain, we have quite a bit for example now. But what about the long run impact? This will depend on the extent of entry, of basically BigTech, which will depend quite a bit on regulation. If I have time, I will make a note of that. Then the degree of competition between the platforms or ecosystems, which are all trying to mobilize the interface with customers, but obviously this might be quite competitive because you are all trying to do the same. And then the degree of competition between these big tech or platforms, if you want, will depend quite a bit of the switching costs, which will be there, and interoperability.
I think the basic idea here is that the easier it is to move from one platform to another, the more competition there will be. The more difficult it is to move from one platform, the less competition there will be. This will be the key of the degree of competition in the market. I am not sure that anti-trust authorities have understood this yet. I'm not completely sure because now we are taking just the abstract, which is like saying that some BigTechs may be too dominant, but maybe they are not paying enough attention to the possibilities of the competition among big techs in entering into the field. This is obviously an opening.
To end, should regulation aim at a level playing field or favor entrants in order to promote competition? What are the implications for financial stability? Just very briefly because there is not much time, but regulation will be key. It's clear that the competitiveness of entrants will depend on the and on the extent of the guarantees that they have or that they not have. It's not clear where we will be with this. Will there be and is there a level playing field? Well, there is not now, and we'll see how it will evolve. For example, in open banking, now there is an asymmetry in information sharing requirements in Europe, for example, between the directive and the privacy laws, GDPR, in the sense that for example, now banks have to open their data if the customer wants, to other competitors, but not the other way. This is something also the European Union is thinking about.
As I said, all the issues of data ownership, portability, and interoperability will be key for the degree of competition. What is being considered obviously is whether there has to be different compliance burdens for dominant player or entrants. Now, the US Congress is looking at it, the UK it looking at it, and also the European Union. This is developed.
An important issue is that a principle that is, I think, regularly established, which is to regulate activities in the sense that the same regulatory rules should apply, is a principle that tries to be applied, is problematic. It's problematic because what fails, if you think about financial stability and we'll have a bridge with financial stability here, is that entities are those that fail. Therefore, regulators are rethinking also that it's not so simple to apply the principle, the same activity, same regulation, because it's not the same. The same activity in a small FinTech than a large FinTech than a large incumbent, for example, because of the systemic effects that it may have in different places.
Another point, which is important has to be taken into account, is that heightened regulatory pressure fosters shadow banking. If you put a lot of pressure on the regulatory entities on the banks, for example, like in mortgage providers in the US, well, then they become, most of the mortgages are provided by shadow banks, of which a good fraction are FinTechs. This is a usual problem that we know on regulation, but that again has to be reformed.
Obviously, what's clear is that consumer protection now is paramount because of the issues that other people have already explained, price discrimination, potential problems with it, privacy, potential exploitation through the digital footprint, a footprint of behavioral biases of consumers, et cetera.
We know that increased competitive pressure decreases profits typically, and in particular of the incumbents. This may increase the incentives to take risks. This has to be taken into account by the regulators, but at the same time, this new technology, we have evidence it makes banks more stable individually, so the banks that are more advanced in IT adoption, they have less non-performing loans. Also, at the end of the day, you have to take into account the new sources of systemic risk, like the contamination of bank and non-bank in platforms, failure of third-party providers, and cyber-attacks, which are becoming more and more important. In fact, cyber-attacks, I think, is something that we'll be talking for a long time. Parallel systems are not yet adequately monitored by the central banks, development of large online money market funds which are not insured. All these are new issues that we have to take into account.
Discussant presentation by Jon Frost
It's a great pleasure to take part today and to discuss this contribution by Xavier. This gets to the heart of the industrial organization issues around FinTechs versus BigTechs versus incumbents in the financial sector and also the public policy trade-offs. There's the triangle that shoved your head in the slides, that discusses the trade-offs between different policy goals. And I think this is really key. There's a lot to discuss here, but I'll be very brief and let you know at the outset that these, the usual disclaimer applies.
We've talked about financial inclusion. And just to give some evidence to this, there has been a really very real impact of FinTech and BigTech players on financial inclusion, at least access to transaction accounts in countries around the world. I'll just highlight that in Sub-Saharan Africa, of course, it's been mobile money that's really driven this big increase in access to the transaction accounts. And mobile money is often provided by telecom providers, who we consider BigTechs. Also, in east Asia and Pacific and in south Asia, you see this really dramatic increase. And of course, the BigTech players, Alipay, Google Pay in India, these have played a very important role.
We talked a bit about the differences between advanced economies and emerging market economies, the potential for leapfrogging. I just want to provide some new evidence here that that could help to put this in context. There is really a bifurcation at the global level. We've seen, if you look at the downloads of the largest finance apps, this is from ongoing research, there's a bifurcation. FinTechs have seen wider adoption in advanced economies. This is in blue on the left. FinTech Apps have been downloaded to a great extent.
BigTech Apps, seen here on the right, have made much larger inroads in emerging market economies. You'll see it. There are some spikes, annual spikes, in this. I'm certain that the annual periodicity in China is a very large explanation for this. Notably, if you look at concentration in the downloads of finance Apps, you can see that it's actually declined over time, both in AEs and EMEs. It's ticked up just a bit recently in AEs, as measured by the Herfindahl Hirschman index.
We see that there is this important difference in FinTechs versus BigTechs in advanced versus emerging market economies, but so far, we've not seen a dominance of the market, at least at an aggregate level. There's this key insight from Chevie's work, which is keys to the industrial organization outcome that we should expect. They know that in the short run, digitalization will increase the contestability of banking services. Mechanically, if there are new entrants then of course there's greater competition and less concentration. But the long run impact is open, and it depends on the market structure that prevails.
One of the scenarios that he discussed was that BigTech firms, together with some platform transformed incumbents, may monopolize the interface with customers, and this is bold for emphasis. They make a convincing case that BigTechs have many of the advantages that FinTechs have without many of the drawbacks. But one drawback that BigTechs, at least in some jurisdictions, may face is trust by consumers to safeguard their data.
We have new evidence. This will be coming out as a BIS bulletin this Thursday. We've looked at trust in different counterparties in the United States, based on the survey of consumer expectations run by the FED. And then we compare this also with views towards willingness to share data with certain counterparts in countries around the world. Now, in the United States, we see that consumers trust traditional financial institutions the most to safeguard their data. They have the most trust in FIs, more so even than in FinTechs or in government agencies. They have the least trust in big techs to safeguard the data according to the survey evidence.
If you look at the international picture, this is from a joint work with EOI, you see a very similar pattern. So here, the comparison is between traditional financial institutions, FinTechs, and non-financial services companies, which includes BigTechs in most cases. Again, you see that in nearly every jurisdiction, people trust traditional financial institutions with their data the most. Of course, they're used to entrusting their transactions data with banks and much less used to using FinTechs or new non-financial services players.
There's one exception to this trend, which I think our hosts may appreciate particularly, which is in China. You can see that the trust in FinTechs is actually higher than in traditional financial institutions. And in the case of China, there were some examples given in the EOI survey. In each case, the examples do include Alipay and WeChat Pay who are of course, BigTechs. But in this case, they were counted as FinTechs. This shows you that there's also some murkiness around the terminology used in some cases of FinTech versus BigTech. But in this case, there actually is higher trust in the likes of Alipay and WeChat pay than in traditional FIs in China. The US and in other countries see a different pattern.
Now, there are a number of responses, and of course, this gets into a lot of issues around financial regulation that Xavier talked about around data privacy and data protection rules and around competition and anti-trust policy. But I'll just mention that there are public policies being tried out to try to mitigate some of the trade-offs, and one, of course, is around public infrastructures.
I think a well-known example that many people have looked at is UPI in India, of course, a retail-fast payment system. What's really striking about UPI is that it is dominated by BigTechs. Google Pay, phone pay, Pay TM, which has investment of course by Ant [Group], are the largest players in India in mobile payments.
What you've seen is that, this is a very fast-growing market. But looking at the market shares within that, the concentration has actually been declining over the past year. As this market is developing, it's allowed, I think, for fair competition between the different providers. Google Pay, phone pay, and Pay TM all offer services to retail clients. They have to compete on a level playing field. And this has been quite a fluid market where each provider has to really compete to maintain retail services.
To some extent, this is a response to the walled gardens. This is an open system that really allows for retail services to be provided in a competitive manner, taking advantage of the network effects of BigTechs, their ability to embed payments services into their apps, which are of course, positive things that users value, but breaking up some of the potential for monopoly that otherwise would emerge.
I think that it's very much in this light that, of course, the Chinese authorities are also considering the ECNY. The ECNY, I think, has been marketed very much as a response to the current payment market, which is dominated by the duopoly of Alipay and WeChat Pay. And the authorities here are very much trying to build a platform and infrastructure on which all of the providers, including the BigTech providers, compete on an even footing, can provide retail services, but then exchanging claims on the central bank, rather than the current approach, which involves funds that are held in escrow and then deposited at the central bank as reserves.
I'll stop there, but just to note that, again, there are very real benefits of BigTech for financial inclusion. We have seen some really dramatic changes. There is this question, I think, as to whether, the monopolization of the client interface will take place as Xavier had mentioned. But at least in emerging market economies, a number of authorities are considering approaches that build a public infrastructure that aims to mitigate some of these tendencies toward monopoly.
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