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Fintech disruption: is it good or bad for consumers?

Mobile banking.
Scott B. Guernsey
Dr Scott B. Guernsey

Financial technology (“fintech”) is a rapidly growing industry that applies recent digital innovations and technology-enabled business model innovations to financial services. A common example is its application of smartphone technologies to banking. For instance, from the convenience of a mobile phone, fintech consumers can access depository accounts, transfer funds, request loans, and pay monthly bills. Correspondingly, the emergence of the fintech industry has expanded the accessibility of many financial services to the general public.

Recent regulation in the EU (the Second Payment Services Directive – PSD2) and the UK (the Open Banking initiative) suggests that policy makers generally regard fintech’s entrance into the financial services industry favourably.[1] Mandated by these respective legislative actions, traditional banks must release data on their customers’ accounts to authorised fintech firms, with the aim of opening “up payment markets”, “leading to more competition, greater choice and better prices for consumers” (Summary of Directive (EU) 2015/2366 on EU-wide payment services). But is the competition/disruption created by fintech firms in financial services’ markets always in the interests of consumers? And what role does the portability of data – as required by the PSD2 and the Open Banking initiative – play in these markets?

A recent research article presented at this year’s Cambridge Corporate Finance Theory Symposium by Professor Uday Rajan (University of Michigan) demonstrates the complex effects that may arise when a fintech entrant and an incumbent bank compete in the market for payments processing. The paper begins by underscoring two important functions that a bank provides to consumers: (i) it processes their everyday payments (e.g. reoccurring bills), and (ii) it offers them loans when requested. Intuitively, these two financial services are interconnected as the transaction data created from processing payments enables the bank to be informed about their consumers’ credit quality. This information externality makes the bank better off and incentivises it to bundle payment services and consumer loans. More surprisingly, the paper finds that consumers can also gain from the bank having their information as more creditworthy consumers are offered better interest rates on their loans.

From this starting point, Professor Rajan (and co-authors, Professors Christine Parlour and Haoxiang Zhu) then show that competition from fintech firms, which act purely as payment processors, can disrupt the bank’s information flow. Consequently, the bank loses market share, consumer information, and becomes less profitable. Additionally, consumers that might need a loan can also suffer from this lost information. Moreover, the entrance of a fintech firm can either decrease or, quite surprisingly, increase the price the bank charges for its payment services. This latter instance occurs if the bank opts to focus its payment business on the population of consumers that are more reliant on (or have a greater affinity for) brick-and-mortar banks, and thus are more tolerant of higher prices. Conversely, the consumer population that is more technologically sophisticated and willing to use fintech services experience the greatest gains as their cost for payment services are reduced by the added competition.

The authors then apply their model to a world in which consumers are given complete ownership and portability of their payment data. They show that this policy effectively unbundles a bank’s payment services from its bank loans, which in turn has different ramifications for different consumers. On the one hand, a certain subset of the consumer population that is more technologically sophisticated and less reliant on a traditional banking relationship is made better off via more choice and lower prices. On the other hand, consumers that have a greater affinity for banks and that are less technologically sophisticated can be hurt by policies that mandate portability of their data because the bank will exploit this smaller group of bank-reliant consumers, charging a higher price for its payment services. These key results underline both the good and bad of fintech disruption and the likely heterogeneous effects of PSD2 and the Open Banking initiative on consumer welfare.

[1] See Directive 2015/2366/EU (25 November 2015), and the United Kingdom Competition and Markets Authority’s (CMA) retail banking market investigation report (9 August 2016).