Balancing the risks and rewards of FinTech

On 3 July 2018, the EBA published two reports looking at the impact of FinTech on business models, prudential risks and opportunities. These reports follow hot on the heels of the European Commission’s FinTech Action Plan and the UK government’s FinTech Sector Strategy Paper published earlier this year, which aim to foster competition and innovation in the financial sector and develop a framework that supports the foundation and growth of FinTech firms.

Report on the impact of FinTech on incumbent credit institutions' business models

Aimed at enhancing knowledge sharing among regulators and supervisors, this report focusses on the current landscape, observed trends and the main FinTech-related factors affecting the business models of incumbent financial institutions.

Key highlights include the following:

1. If you can’t beat them, join them. According to the report, collaboration between credit institutions and FinTech firms is the prevailing business model among the different ways that incumbent firms are interacting with FinTech. Incumbents have been taking a more strategic, long-term view, looking to invest in FinTech start-ups (often through venture capital funds, rather than acquiring them directly). Whilst collaboration appears to be a “win-win” for both sides, in many cases it remains to be seen whether integration will be successful and how it will translate in monetary terms for the incumbent banks.
2. The main drivers. The four mains drivers for incumbents adopting FinTech into their business models are identified as: (i) customer expectations and behaviour; (ii) profitability concerns; (iii) increased competition; and (iv) the regulatory framework. Out of a survey of 37 European banks, all of them expected FinTech to increase their revenues and 97% hoped it would increase their customer base.
3. Striking a balance. Customer trust is a key advantage that incumbent banks currently have over FinTech firms. Although the trend is for easier access, faster service and intuitive interfaces for customers, incumbent institutions are also cognisant of the need to build upon that trust and strike a balance between digital-only banking and maintaining physical banking for customers who are less keen to use online channels. That said, the number of customers using daily banking, payment or investment services provided by new entrants and other FinTech firms is growing, and increased customer mobility (also facilitated by APIs) is expect to be a significant driving force in the future.
4. FinTech firms eating incumbents’ lunch. The report finds that the payment and settlement business lines of incumbents are being most affected by FinTech in terms of revenue and costs. By focussing on gaps in traditional banking products and services (such as convenience, user experience and functionality), FinTech firms are eroding fees linked to payment services and commission income. FinTech firms are also becoming active in non-capital-intensive business areas such as cross-border transfers, micro-payments or card payments, significantly increasing competition in the retail banking sector.
5. Where the opportunities lie for incumbents. The report indicates promising opportunities for incumbents in commercial banking and trading and sales business lines due to the benefits of new technology-based propositions such as commercial banking aggregator models, use of robo-advice and application of better data analytics. In particular, some institutions are focussing on building new digital experiences through their API platforms in order to create new value-added services and enhance user experience. Institutions are also heavily investing in cloud-based solutions (in relation to which, the EBA’s recommendations on outsourcing to cloud service providers applied from 1 July 2018).
6. Two-pronged approach. Generally, incumbent institutions are establishing two dedicated innovation functions, one responsible for overall strategic investment in FinTech start-ups (including setting up and running venture capital funds and identifying potential targets) and the other looking at the development of innovative solutions, for example through sandboxing / accelerator schemes. Some institutions have also incorporated advisory panels consisting of technology experts within their corporate governance structure.
7. A cultural shift. Many institutions consider staff mindset to be a key impediment to the implementation of their innovation strategies. To overcome this challenge, some have appointed a ‘digital champion’ in each team / unit, responsible for driving the transformation process. Others have sought to invest in their existing staff through the delivery of training courses and workshops, as well as encouraging greater interaction with FinTech firms through participation in accelerator programmes.

Prudential risks and opportunities arising for institutions from FinTech

This report aims to raise awareness, within the supervisory community and the industry, of current and potential FinTech applications and the associated potential prudential risks and opportunities that may arise.

The report assesses the following seven use cases, where new technologies are applied or considered to be applied to existing financial processes, procedures and services:

• Biometric authentication using fingerprint recognition;
• Use of robo-advisors for investment advice;
• Use of big data and machine learning for credit scoring;
• Use of distributed ledger technology and smart contracts for trade finance;
• Use of distributed ledger technology to streamline customer due diligence processes;
• Mobile wallet with the use of near-field communication; and
• Outsourcing core banking/payment system to the public cloud.

Key findings include that:

1. There has not yet been a significant implementation of sophisticated technologies by institutions, potentially due to security concerns and filtering the hype around FinTech.
2. From a prudential risk perspective, there is a growing shift towards operational risk, arising mainly from the accentuation of ICT risks, as institutions move towards more technology-based solutions. Dependencies on third-party providers, heightened legal and compliance risks and negative impact on conduct risk add to the overall increased operational risk.
3. The potential efficiency gains and the improved customer experience appear to be the predominant key drivers when it comes to potential opportunities. In addition, changing customer behaviour is a key factor triggering institutions’ interest in FinTech.
4. The use of biometrics for identification and authentication purposes and the launch of mobile wallets with the use of NFC technology are some of the FinTech applications already implemented by institutions.

Osborne Clarke comment

Following the recent implementation of the GDPR and PSD2, issues of data protection and customer consent are a key focus for all institutions. From a technology, operational and strategy perspective, these regulatory changes will not only re-shape business models, but are likely to fundamentally change the way in which institutions approach issues of security and data privacy.

PSD2 has also revolutionised the payments sector through the introduction of account information and payment initiation services. This has the potential to further open up the banking information and online payment space to FinTech firms, who can now gain access to data which previously was only available to incumbents. This is likely to facilitate new business models in the retail payments market, enabled by mobile wallets which encompass innovative technologies such as mobile banking, digital wallets, biometric authentication and NFC.

On 4 July 2018, the BoE published its discussion paper ‘Building the UK financial sector’s operational resilience’. Technical innovation (FinTech, artificial intelligence, distributed ledge technology and crypto assets) is identified as one of the key challenges to building the operational resilience of financial institutions. It will be interesting to see the industry feedback to this paper (responses are due by 5 October 2018), and how this shapes supervisory authorities’ approach to operational resilience going forward.